Slow and steady wins the race. Investors seeking an exchange traded fund strategy that can produce attractive risk-adjusted returns over the long haul should take a look at the low-volatility theme.
“Imagine a race between a speedy, boastful hare and a steady, quiet tortoise,” Andrew Ang, Head of BlackRock‘s Factor Based Strategies Group, mused in a research note. “You can think of minimum volatility strategies as akin to the tortoise – humble and sometimes overlooked, but a formidable participant in the race over the long term.”
The low or minimum volatility strategy targets stocks that have lower expected risk or less idiosyncratic risks. Specifically, the strategy targets equities that exhibit lower beta, a measure of volatility or systematic risk of a security to that of the overall market. Consequently, minimum volatility portfolios are constructed with stocks that exhibit lower market risk or beta.
“But just because these stocks are low risk doesn’t mean they have low returns,” Ang said. “Minimum volatility strategies have delivered reduced risk, but with market-like returns.”
For ETF investors, low-volatility strategies could produce better risk-adjusted returns, or help diminish drawdowns during times of heightened market selling while allowing an investor to participate in any upside.
[related_stories]Ang compared the MSCI USA Index to the MSCI USA Minimum Volatility Index from January 1, 2001 to January 31, 2016 and found that the minimum volatility index produced better risk-adjusted returns. Over the period, the standard market cap-weighted U.S. index showed an average 4.63% return with a 15.11% measure of risk, whereas the U.S. minimum volatility index had a 6.65% return and a 11.54% risk measure.
The strategist attributes the outperformance lower volatility to structural impediments and a behavioral bias. Specifically, structural impediments or rules and restrictions that may make some investments off limits to certain investors, which have fueled a preference toward high-flying stocks in hopes of higher returns. Behavioral bias refers to the observation that the average investor may not be rational and may bet on higher flyers even in the face of greater risks.
ETF investors interested in the minimum volatility strategy have a number of options across various markets to choose from. For instance, the iShares MSCI USA Minimum Volatility ETF (NYSEArca: USMV), which tracks the MSCI USA Minimum Volatility Index, selects U.S. stocks based on variances and correlations, along with other risk factors.
Investors can also target European market exposure through the iShares MSCI Europe Minimum Volatility ETF (NYSEArca: EUMV).
For more targeted Asia exposure, investors can look at the iShares MSCI Japan Minimum Volatility ETF(NYSEArca: JPMV) and the iShares MSCI Asia ex Japan Minimum Volatility ETF (NYSEArca: AXJV).
ETF investors can also take the low volatility theme to broader overseas markets. The low-volatility ETFs have helped soften the blow from the global sell-off. For example, the iShares MSCI EAFE Minimum Volatility ETF (NYSEArca: EFAV) provide a low-volatile option for developed overseas markets. The even broader iShares MSCI All Country World Minimum Volatility ETF (NYSEArca: ACWV) employs the MSCI minimum volatility selection process on the benchmark All Country World Index. Additionally, investors can target emerging market exposure through the iShares MSCI Emerging Markets Minimum Volatility ETF (NYSEArca: EEMV), a low-vol variant on the widely observed MSCI Emerging Market Index.
However, potential investors should be aware that since these ETFs focus more more slow and stable companies, the low volatility strategy may underperform more growth-oriented stocks if the markets turn around. Ang points out that during periods when volatility was highest, min-vol strategies outperformed the market by an average of 8% with nearly 6% less risk. On the other hand, low-vol portfolios underperformed by about 2.5% on average and risk reduction was limited to 0.2% during periods of low-volatility.