Low Vol ETFs Not Necessarily Low Risk

Rising P/E ratios will challenge their ability to outperform.

Reviewed by: Trevor Hunnicutt
Edited by: Trevor Hunnicutt

New York (Reuters) – Exchange-traded funds that focus on defensive shares have grown more expensive than their traditional rivals, testing whether the funds can continue to make good on their promise to deliver better-quality returns than the market.

The price-to-earnings ratio, a measure of a stock's cost, was over 22 for the iShares MSCI USA Minimum Volatility (USMV | A-75) and the PowerShares S&P 500 Low Volatility Portfolio (SPLV | A-62) over trailing 12-month periods measured last week. That compares with the PE ratio of 18 for the plain-vanilla SPDR S&P 500 (SPY | A-99), according to Morningstar Inc.

With a long winning streak, "low volatility" and "minimum variance" are attracting investors by promising better-quality returns and less risk than the overall market.

Trade’s Best Day May Be Over

But Robert Williams, research director at Sage Advisory Services Ltd Co., says the trade's best days may be over.

"It worked, but it's going to stop working at some point," said Williams, whose company recently sold its stake in SPLV and bought SPY.

Defensive funds have largely sidestepped technology and energy declines. Over a three-year period through Wednesday, USMV returned 12.5%, SPLV rose 11.6% and SPY gained 10.3%, Lipper said.

BlackRock Inc. said USMV is its best-selling U.S. stock ETF, bringing in nearly $1 billion this year.

Reducing Churn

The lower-volume funds redesign traditional benchmarks, like the S&P 500, demoting companies like Apple and crowning new top holdings, like AT&T. Such moves are expected to subject investors to less churn.

But they can take on bets of their own, including growth stocks and dividend-payers, and have moved in tandem with Treasurys as the safe-haven assets have rallied. But those bets could take a hit if dividends—and bond values—are sliced if and when the Federal Reserve raises interest rates.

Unsurprisingly, the funds favor more stable sectors, such as health care, utilities and consumer staples.

Low-Vol Stocks Can Be More Rate Sensitive

"There is more rate sensitivity in lower-volatility stocks. However, the historical evidence is mixed as to when that plays out," said Robert Nestor, an iShares strategist. "The strategy has very rarely underperformed the broader market in downdrafts."

John Feyerer, strategist for PowerShares, says valuations do not predict lower-volatility strategies' future performance.

Different Construction

Nuances between the funds lead to different results.

The $5.6 billion SPLV has no constraints on its sector bets, allowing it to concentrate more assets in certain industries.

The $7.8 billion USMV, by contrast, limits sector exposure to a range derived from its parent index.

That means the funds' returns are not easily predicted. While SPLV trails over three years, it has outperformed over the last three months, Lipper says.

Trevor Hunnicutt is a staff writer for Reuters.