A Low Vol ETF’s Big Reshuffle

Sometimes factor investing can seem counterintuitive. In a year like 2020, when volatility went through the roof as markets digested a global pandemic and an economic shutdown, the Invesco S&P 500 Low Volatility ETF (SPLV) didn’t offer the respite you might have expected.

Year to date, SPLV, which tracks the S&P 500 Low Volatility Index and invests in the 100 least volatile stocks in the S&P 500, has lagged the SPDR S&P 500 ETF Trust (SPY) by almost three times:

Low vol investing, longer term, is said to offer not only some downside protection by focusing on the least volatile stocks, but better risk-adjusted returns than the overall market over time. S&P Dow Jones recently published the following data to support that idea:

Wrong Side Of The Track

But that outperformance hasn’t happened this year, and the divergence between SPLV and SPY really became evident beginning in March.

Why? Because sometimes when you seek to capture a pure factor anomaly, performance can deviate dramatically from the broader markets. In a year when the stock market no longer is running higher across the board, sector allocation has mattered immensely. SPLV, which is built from the bottom-up, seeking the lowest volatile stocks in the S&P 500 regardless of what sector they belong too, found itself heavily invested in all the wrong sectors.  

The global pandemic and economic shutdown led to major disparity between sector performance. In 2020, there have been clear winners and losers in the face of the unprecedented.

Coming into its quarterly rebalance, SPLV tilted heavily to sectors that are traditionally defensive and lower risk—the fund had 27.4% of its portfolio tied to utilities; 15.2% to REITs; 15% to financials.

But these were the segments of the economy investors punished the most as the economic shutdown and massive rise in unemployment put in question consumers’ ability to pay their electric bills and their rent. Federal Reserve action pushed rates lower, weighing on financials.  

It was the perfect storm for SPLV.

New Face Of Defensive

“What were low vol stocks before the pandemic became much more volatile in the face of the pandemic,” said Nick Kalivas, senior equity strategist at Invesco. “SPLV was positioned poorly for that turn of events. This wasn’t the first time that SPLV was caught on the wrong side. During the taper tantrum in 2013, we also saw big downside capture.”

This time around, who would have guessed that a year like 2020 would have made technology a more defensive sector than utilities? Communications and health care standout performers?

These sectors have been leading gains in an economy that now works from home and thinks about nothing other than finding a cure or a vaccine to combat a pandemic. They've also been better supported on the downside. 

Big Reshuffle

Going forward, SPLV is now ready to leave this year’s dismal performance behind it. 

In its most recent quarterly rebalance, which takes into account the last 12 months of volatility to adjust holdings, the fund turned its sector allocation on its head.

SPLV has made its biggest-ever tilt toward health care and communications services; its second biggest ever bet on technology. It's in these sectors that the least volatile stocks in the S&P 500 today reside. Look at the before and after:

SPLV Sector Allocation

Source: Invesco

Will it work? SPLV's mandate to capture the lowest volatile stocks goes on unchanged, offering investors the opportunity to capture this anomaly regardless of sector bets it may make along the way. 

But consider that a similar sector allocation in the competing iShares Edge MSCI Min Vol U.S.A. ETF (USMV) has worked relatively well this year. USMV doesn't set out to invest in the least volatile stocks, but it's designed to offer a smoother ride by delivering a portfolio that, in the aggregate, has lower absolute volatility. The fund looks at correlations between stocks when looking for low vol names, and avoids big sector bets, so its portfolio may not own the least volatile companies, but delivers a ride that's about 25% less volatile than the broader market. 

From a sector allocation perspective, that methodology has put USMV's biggest allocation to technology at 19.1%; with health care also near the top, at around 12%.

Year to date, USMV has only marginally lagged the S&P 500:

Charts courtesy of StockCharts.com

Factor Persistence

“Typically, longer-term analysis shows volatility in one year tends to be consistent with the next,” Kalivas said, noting that about two-thirds of the least volatile stocks in the S&P 500 in a given year rank again among the least volatile in the following year.

“There’s persistence to volatility,” he added. “There’s still plenty of uncertainty in the market going forward, from the pandemic to the possibility of a second wave of COVID-19, to the presidential election, to China trade issues. Let the low vol anomaly play out.”

The takeaway here is that if you are a true believer in the low vol anomaly, and you believe in the long-term persistence of this risk factor, SPLV offers the purer capture relative to USMV. But that also means you may have to brace for surprising bouts of volatility in SPLV given its sometimes dramatic sector tilts. And if you simply want a less bumpy ride in the aggregate, USMV might work well for you. 

Either way, so far in 2020, investors have not embraced the ride, taking more than $1.2 billion in net assets from SPLV. In the past three months or so, the fund has seen only one day of positive inflows since March 19.

USMV has managed to stay net positive, but barely, with only $106 million in net creations year to date. Compare that with the ETFs’ blockbuster success in 2019, when low vol investing was all the rage. SPLV and USMV captured more than $14 billion in combined net assets over 12 months.

Contact Cinthia Murphy at [email protected]