Why low-volatility ETFs are now a high-stakes gamble

roller coaster2My Comments: I don’t normally post anything on this site on weekends. But there is so much going on these days that I either have to start posting twice a day during the week or from time to time on the weekend.

ETF’s are as significant a step in the evolution of money management as were mutual funds in the early part of the 20th Century. I’m increasingly using them when it comes to my money and to that of my clients. For those of you that find all this mind numbing, please feel free to ignore it. (My source article is found HERE.)

By John Prestbo July 27, 2016

Wall Street is doing a booming business with investors who want to avoid the jitters brought on by a rocky stock market. So booming, in fact, that the performance and purpose of low-volatility investments now pose the very risks they were meant to avoid.

More than $50 billion has poured into low-volatility indexed exchange-traded funds over the past five years or so, in the wake of the 2008-09 market meltdown. There are now 14 “lo-vol” ETFs with assets exceeding $100 million each, and many more with less. Whenever the market hits a pothole, these ETFs enjoy a bump-up in assets.

Six ETFs in the lo-vol space have attracted more than $2 billion of assets apiece. The oldest fund is PowerShares S&P 500 Low Volatility Portfolio SPLV, +0.12% which began trading in May 2011 and now lays claim to almost 20% of lo-vol assets.

Yet the second-oldest lo-vol ETF is actually almost twice as large. The iShares Edge MSCI Minimum Volatility USA ETF USMV, +0.21% dominates the group, with close to 40% of the assets. One reason may be that it has the lowest management fee among the top six. Its success, in fact, spawned an iShares family of lo-vol ETFs with the “Edge” brand.

These ETFs mostly live up to their billing. Most of them achieve low volatility by holding those stocks in an index that fluctuate less than the overall index. Some newer models contrive triggers to move out of stocks and into cash when the market slumps, and to move back into stocks when the slump ends.

Whatever the methodology, lo-vol ETFs aim to be a sleep-better substitute for the broad-market indexes from which they are derived. They decline less in downturns, but tend not to rise as much in rallies — or take longer to get to the same place. Investors tend to overlook the “hidden” cost of this upside gap.

On its website, iShares says its minimum volatility USA ETF historically captured 83% of a broad index’s up months and 44% of the down months. Curiously, iShares uses the S&P 500 SPX, +0.16% rather than the MSCI USA index to calculate these statistics. By contrast, PowerShares declares on its website that its lo-vol ETF delivered 77% “up-capture” and 43% “down-capture” since inception.

That means, for a $10,000 investment and a base index that rises 10%, the iShares ETF would leave $170 on the table from a potential $1,000 gain and the PowerShares ETF would leave $230. Those amounts may look like hotel-room rates, but the upside shortfalls accumulate over time.

In other words, the longer you want to sleep well, the more expensive it could get in terms of foregone capital appreciation.

This year’s market potholes so far — the year-opening tumble and the surprise Brexit vote — are not good illustrations of how lo-vol vehicles are supposed to work. These ETFs did fall much less than the base indexes in both cases, though the “downside capture” was larger than average.

But both of these ETFs bounced back more quickly and strongly than the base indexes. Indeed, these lo-vol ETFs are more than doubly outperforming their base indexes this year through July 22.

This upside-down situation is the result of all the assets pouring into these lo-vol ETFs. The iShares fund is the third-largest asset-gathering ETF this year, according to ETF.com — and as always, money coming in pushes prices up. Another result: The lo-vol ETFs this year are roughly 25% more volatile than the market.

These conditions won’t last. Reversion to the mean could disillusion investors already holding lo-vol vehicles. And for those thinking about adding lo-vol to their portfolios this state of affairs is a red-light warning that now probably isn’t the best time to get in.

Whether any time is right for lo-vol is a personal decision because it touches on fear about loss. If every little market swoon pumps up your blood pressure, lo-vol may be the answer. But be aware of the costs and consequences.

John Prestbo is retired as editor and executive director of Dow Jones Indexes, now part of S&P Dow Jones Indices, in which Dow Jones & Co., publisher of MarketWatch, holds a small interest. Prestbo also is an adviser to MarketGrader Capital, which scores stocks on the basis of fundamental factors and chooses components of the Barron’s 400 Index.