In the valley of the newly anxious, does the smart-beta ETF win?
A theme coursing through the panels at Inside ETFs this year is that investors now seem more focused on risk management than market outperformance. The trend helps explain why low-volatility ETFs have attracted a lot of attention in recent months.
A fund like the 2 ½-year-old iShares MSCI USA Minimum Volatility ETF (USMV | A-54), for instance, has more than doubled in size in the past 12 months, attracting more than $1.38 billion in fresh net assets during the period. It now $2.5 billion in total assets.
USMV overweights defensive, dividend-paying sectors like health care, utilities and consumer staples in a portfolio designed to track an index of U.S.-listed firms weighted in ascending order by their volatility, according to ETF.com’s ETF Analytics.
USMV is a good example not only of investor interest in low-volatility stocks, but also of the surging demand for factor-based investing, or smart-beta ETFs. In 2013, these nonmarket-cap weighted strategies gathered more than $45 billion in total assets. No one sees that demand slowing down.
“The growth in the ETF industry has democratized the access to many of these factor strategies that have been around for years,” David Koenig, investment strategist at Russell Investments, told ETF.com on the sidelines of Inside ETFs. “The structure of the ETF has helped popularize this approach to investing.”
But the broad market environment has also played a role in the growth of this segment, as investors look for fresh ways to allocate assets five years after the subprime mortgage crisis caused a dramatic market crash and nearly brought the global economy to its knees, Koenig said.
Speaking on a panel with other factor-investing experts, Koenig noted that the proliferation of the use of these nonmarket-cap funds requires advisors and investors to continuously look under the hood and make sure they understand what it is that the factor-based ETF is setting out to do.
“It’s important to understand that the ‘smartness’ of smart-beta indexes comes from implementation, not from performance,” Koenig said. “There are periods when these strategies outperform and there are times when they underperform.”
A look at a chart plotting USMV’s performance and the SPDR S&P 500 ETF (SPY | A-97) is a good example of how isolating volatility as a factor didn’t translate into outperformance in the past 12-month period.
Chart courtesy of StockCharts.com
Another interesting aspect of low-vol investing is that the entire premise of over-allocating to low-vol stocks is that low-beta stocks deliver positive alpha, Nick Cherney, chief investment officer and co-founder of VelocityShares, pointed out.
But that doesn’t mean low-vol funds like the PowerShares S&P 500 Low Volatility ETF (SPLV | A-47) have lowered portfolio risk.
“There’s a significant difference between a portfolio of low-vol stocks and a low-vol portfolio,” he said. “You need to pay attention to what you’re getting.”
SPLV tracks a volatility-weighted index of the 100 least volatile stocks in the S&P 500 designed for risk-averse investors looking for exposure to the S&P 500. In the past 12 months, investors yanked a net of $59 million from SPLV, even as it rallied 14.7 percent. The fund has $3.6 billion in total assets today.
“SPLV is a portfolio of low-vol stocks, while USMV is optimized, aiming for an overall low-volatility portfolio,” Cherney said. “You have to understand the difference, and know your objective.”
“Beta is not smart, but the user should be,” Will McGough, portfolio manager with Stadion Money Management, added at the panel discussion. “You need to know when these factors work and when they don’t.”