What should you do with a group of exchange-traded funds that fail to live up to their name? That’s the question being bandied about these days regarding low-volatility ETFs. As the name suggests, these funds are built to be quite stable in the face of choppy market conditions.
Yet they weren’t much of a safe haven during the recent market swoon. From January 29 through February 8, the S&P 500 Index slid 9.6 percent. During that time the iShares Edge MSCI Min Vol USA ETF (USMV)—which is the largest low-volatility ETF with $14.4 billion in assets—wasn’t much better with a loss of 8.5 percent. That’s not the kind of defensive ballast many investors assumed they were getting.
“Low-vol” funds adhere to their mandate by owning low-beta stocks, which offer the promise of smoother ups and downs relative to the rest of the market. Todd Rosenbluth, director of ETF & mutual fund research at CFRA, has a simple explanation for the poor recent performance of such funds. “Low-beta stocks in these funds are also often solid dividend payers,” says Rosenbluth.
And a focus on yield-oriented sectors is precisely the wrong end of the market to be in right now with interest rates starting to rise. The yield on the 10-Year Treasury bill has surged from 2.40 percent when the year began to a recent 2.90 percent. Rising fixed-income yields tend to steadily siphon demand away from equity yield plays.
And the bond rout could deepen. A newly-revised forecast from Goldman Sachs Asset Management (GSAM) suggests the U.S. Federal Reserve will raise interest rates four times this year (compared to the consensus forecast of three hikes). The fed’s move to unwind its balance sheet as it sells assets acquired in the quantitative easing (QE) cycle may also spur a further back up in yields. Six months from now, the 10-Year yield could rise to 3.50 percent, according to GSAM.
A rising rate cycle means you should currently underweight your exposure to any funds that have a heavy weighting in dividend producers. The Legg Mason Low Volatility High Dividend ETF (LVHD), for example, has more than 60 percent of its portfolio invested in dividend-producing sectors such as utilities, consumer defensives, real estate and industrials.
That figure drops to around 44 percent for the iShares Edge MSCI Min Vol USA ETF and 55 percent for the PowerShares S&P 500 Low Volatility Portfolio ETF (SPLV). Those two funds carry expense ratios of 0.15 percent, and 0.25 percent, respectively. The LVHD fund’s expense ratio is 0.27 percent.
Risk-Adjusted Returns
Most low-vol funds weren’t around during the last major market plunge and have yet to be tested in such extreme environments. Both the PowerShares and iShares funds, for example, were launched in 2011. As expected, they have slightly lagged the S&P 500 by one to two percentage points annually in that time, due to their defensive posture.
Despite modest underperformance during bull markets, exposure to defensive ETFs like these low-vol funds makes ample sense if you want to preserve capital during the next major market sell-off. Rosenbluth says that these funds have generally proven to hold up well in times of market stress, the recent interest rate-fueled sell-off notwithstanding. “We still think low-vol products make a lot of sense for investors that want to stay in the market, but with less risk,” he says.