Note: This article is part of the ETF Trends Strategist Channel

By Joe Smith, CFA

So far in 2016, we’ve seen a large amount of net inflows into minimum-volatility ETFs as investors seek shelter in lower-risk stocks. These smart beta ETFs are designed to target the factor premium that has been attributable to favoring lower-risks stocks over their higher-risk counterparts.

Recent press, articles, and whitepapers have sharply criticized the minimum-volatility trade, and some have said that the higher valuations associated with these types of stocks are evidence of overcrowding by investors. This type of behavior suggests the premium investors harvest for owning such securities is likely to come tumbling down sooner rather than later.

Like all investment strategies, minimum volatility cycles through outperformance and subsequent underperformance over periods of time. Based on the conditions described above, should investors be thinking about rotating back out of minimum-volatility ETFs?

Minimum Volatility Persistence Falls Out of Bounds of MPT and CAPM

Premiums in any factor exist due to behavioral decisions made by investors that hold them back from quickly arbitraging that premium. The nature of owning lower-risk stocks over higher-risk stocks runs counter to the foundations of modern portfolio theory (MPT), and the capital asset pricing model (CAPM) simply due to the notion that investors should be rewarded incremental returns for taking on greater amounts of risks. The minimum-volatility trade has existed and persists largely because investors prefer going after opportunities that have higher risks and higher returns. This behavioral deficiency tends to result in minimum-volatility stocks having less price efficiency — not more.

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