Here Is Why Low Volatility ETFs Are So Popular

Smart beta strategies are becoming more popular among wealth managers, said a recent report commissioned by Invesco's PowerShares. The research predicts the proportion of European portfolios allocated to alternative index products will rise to 16% from 9% within three years.

Independent financial advisers and wealth managers are now using smart beta products to construct client portfolios. Bryon Lake, head of Invesco PowerShares for EMEA, said: "These strategies appeal because they allow to the wealth manager to achieve a specific goal."

The goal might be to exploit a proven investment strategy such as accessing value stocks, choosing higher yielding shares or managing the risk profile of a portfolio by selecting low volatility stocks. Lake said: "These products have a straightforward investment target which enables these products to be used as portfolio building blocks."

Lower Costs

The lower cost of these products is also appealing, particularly for investors in the UK, according to the report. Smart beta gives investors access to strategies which were previously only available from an active or quant manager and at a much lower price.

Even though the number of strategies available to investors has grown rapidly this year, investors prefer certain strategies. Lake said: "Low volatility strategies have been popular so far this year and have seen strong inflows both globally and in Europe."

It's not just PowerShares which has observed the popularity of low volatility strategies – index and platform providers have also noted the trend.

Minimum Volatility Taking Off

Deborah Yang, managing director and head of the MSCI index business in EMEA and India, said: "Global ETF assets tracking our minimum volatility indices have grown by 80% year-to-date."

Tim Edwards, senior director of index investment strategy at S&P Dow Jones Indices, agreed: "Smart beta risk management products, such as low volatility, have proved slightly more popular than income strategies."

Adam Laird, head of passive investment of Hargreaves Lansdown, added: "Low volatility has been particularly popular among discretionary managers."

Pinpointing exactly why low volatility smart beta strategies have proved more popular than other smart beta strategies is not straightforward. A number of different trends have coalesced to make low volatility the most sought-after strategy.

Key Smart Beta Catalysts

The global financial crisis played an important role. Edwards said: "Investors are now focused on managing the risks associated with their portfolio as well as targeting returns."

Investment techniques have also become more sophisticated. Many of the risk management and asset allocation techniques, which were once only the preserve of the institutional investor, have trickled down to wealth managers.

Not only is there increased demand for these products – supply also increases. Once asset managers see that a product has been successful with institutional investors, they will often get the necessary marketing budget to be able to offer it to wealth managers, said Jason Hsu, vice chairman at Research Affiliates.

In particular investors have learnt that controlling volatility should be given a greater priority, particularly for those with a fiduciary role. That's because there is a greater awareness of the long-term negative impact on the value of a portfolio if it fluctuates by a significant amount.

"An investor is much worse off losing and then regaining 50% of their portfolio then losing and regaining 5%," said Edwards.

A portfolio with a value of £100,000 would only be worth £75,000 if the value fell and rose by 50% whereas it would still be worth almost the same as its starting value if it were to fall and rise by 5%. Effectively there is a long-term bonus for managing risk, said Edwards.

Hsu added: "In addition, there is a growing awareness that we are likely to be in the later stages of the bull market which means volatility is likely to increase in the future."

Evident Underperformance

It's not only, however, a greater emphasis on risk management which is driving a higher allocation to low volatility – these strategies have also outperformed the market since the financial crisis.

Edwards said: "If strategies perform well, investors tend to allocate more funds to these strategies. But there are no guarantees this outperformance will continue." Like every other investment strategy, performance is cyclical. In the late 1990s, for example, this strategy underperformed the market.

And there could well be challenges to this outperformance on the horizon. Shaun Port, chief investment officer at Nutmeg, said: "These strategies can behave like a proxy for bonds."

That's because a minimum volatility portfolio tends to be overweight in those sectors which are more effected by rising interest rates – such as utilities. And just like bonds, their performance value rises when yields fall and they depreciate when rates rise.

The performance of these strategies could be close to an inflexion point: the likelihood of the US Federal Reserve hiking the cost of borrowing later this month is increasing. Port said: "We are concerned about the performance of the low volatility strategy in this environment."

There are also concerns that the popularity of low volatility has made this a crowded trade. Hsu said: "The average basket of low volatility stocks has become more expensive." Historically these stocks would typically trade at 20% to 25% discount to the market index.

But over the last five the popularity of these stocks has pushed the value of low volatility stocks to a premium rather than a discount to the market. Hsu said: "This is a very significant shift."

Relative valuation is a very good predictor of future performance – more expensive stocks have lower returns. Hsu said: "This suggests that in the future people will still be able to protect their portfolios from volatility but returns are unlikely to be better than the market."