Low-Volatility Funds: The Good, The Bad and The Unpredictable

By: Cameron Roth, Portfolio Manager, THOR Financial Technologies, LLC

“Low-volatility funds” are a financial oxymoron on several levels.

First, they claim to be less volatile than other mutual funds, but all bets are off to reduce exposure to huge swings in today’s rollercoaster market.

Second, they have grown to be an asset class amassing more than $50 billion in AUM, but investors are struggling to understand what particular assets they’re buying. Third, they strive to be low risk, but that’s not always the case when there’s a false misconception about their sense of security. And fourth, ETFs don’t advertise drawdown protection when potential market stress is on the horizon. In fact, USMV’s prospectus claims it “does not seek temporary defensive positions when markets decline or appear overvalued.” A Simple Methodology Not Always Simply Executed.

Typically, the methodology behind low-volatility funds is to find stocks with recent stability and incorporate them into a fund. It’s a simple methodology. However, this has created myriad issues in the past that may be replicated again in the future. For beginners, USMV has historically had a standard deviation of 14.8% over the past five years and 12.0% over the past ten years. When compared to 18.3% and 14.5% respectively for SPY, that’s not exactly stable, is it?

Additionally, EFTs may fulfill their ambitions of experiencing slightly lower volatility than broader indices, but this concept falters when investors rely on these products during periods of market stress and extreme volatility.

The Coronavirus Infected Markets, Too.

As an example for what can happen after one widely unexpected global pandemic spreads globally, COVID-19 was the catalyst for market downward spirals not seen in decades –– though the markets made amazing gains from their lows by that year’s end:

• From February 19 – March 23, 2020, the S&P 500 lost 33.38% with a standard deviation that jumped to a record 61.2%.

• Not to be outdone, over the same time period, USMV dropped a nearly identical 33.05% and its standard deviation jumped even higher to 67.8%.

• Meanwhile, SPLV declined 36.20%, while LGLV fell 36.45% with standard deviations rocketing to 74.2% and 68.3%, respectively.

But Wait! There’s Even More Volatility.

The problematic dynamic of these funds extends beyond just the lack of volatility management in times of stress. Their recovery is also set up for underperformance because of the nature of their particular parameters. The “low volatility” stocks inside these funds can be comparable to value or household names such as Pepsi, Walmart, Johnson & Johnson etc. During disruptive market mayhem in the past, all stocks have been taken to the woodshed, leaving all equity exposure susceptible to losses on paper and emotional pain. Then, during periods of recovery, investors search for new growth emerging from the rubble, pushing value and quality aside since they’re no longer needed.

Another Example From 2020.

Using 2020 as another snapshot in time, from the depth of the COVID crash, SPY gained nearly 70% through the end of that year compared to a 48.7% gain for USMV. In what may go down as one of the most volatile years in history, the result was an S&P 500 gain of 18.37%; meanwhile, USMV gained a mere 5.64%, LGLV rose 7.46%, and SPLV lost 1.37% on the year. Putting it all together, volatility on the downside matched the broader indices, it offered investors no such volatility management, and its performance was dampened with the upside recovery, greatly hindering results and leaving investors behind.

Two Years Later, It Became a Success Story.

Jump to 2022 and the story appeared successful. USMV has almost mirrored the Dow in outperforming the broader S&P to date this year. The story makes sense macroeconomically as rates near zero and QE allowed growth multiples to grow out of control. But all good things must end. Inflation spiked, rates shot up in response, and QT has begun. The macro environment has favored a rotation out of growth and into value, quality staples which is evident by a QQQ down 28.8% YTD through November 21st, and a DIA only down 5.6%. All of this beneficial to low volatility funds.

The Future: Analysts Offer Different Scenarios.

However, where the problems may lie in the future comes from a rebalance only once every six months combined with a focus strictly on past low volatility metrics. Therefore, the general makeup of a low-volatility fund’s allocation is likely to remain similar for some time. The ongoing problem is cyclical. The rotation caused by a change in the macroeconomic environment has benefitted the funds so far this year; however, it’s likely to be the same reason for its underperformance in the future. This rotation has allowed the underlying stocks to become quite expensive. USMV sits at a trailing twelve-month P/E of 21.7, while SPY and DIA each sit at 19.3 and 18.6, respectively. The tech focused QQQ is not much higher at 24. Analysts portray a wide array of possible outcomes for the economy and its markets for the next year. Each scenario, however, is likely to see a lack of performance for the now expensive low-volatility funds.

• Scenario #1 –– There could be an economic recession matched with declining earnings, and subsequently, a declining stock market. If the recession results in a 20% earnings decline, a 15x multiple may be fair for the market and the S&P 500 may trade down near 3,000. In this scenario, similar to COVID, no one will be immune and stocks everywhere will be hit and funds like USMV could have more to fall than the S&P due to the premium it currently trades with.

• Scenario #2 –– On the other side is a recovery. When markets recover, they ditch the quality stocks they thought were going to protect them and look for growth opportunities. So a similar playbook to 2020 is in play, just maybe not as swift as the COVID crash and recovery, where the decline is equal or greater than broader markets and the recovery lags.

This analysis is a soft landing. The consumer and job market have remained resilient, inflation seems to be cooling, it’s quite possible the economy, consumer, and stock market survive with the worst already behind us. Earnings could grow instead of contract and the multiple will deserve to be higher, pointing to a market a little bit higher than where we sit currently. While this scenario sounds ideal, something to consider is how investors will react. They’ve loaded up on “safer” securities because the macro environment called for it (which was correct) and also because of fear of recession.

USMV Is Set For An Earnings Contraction.

Regardless of how the economy plays out, USMV is set to experience a contraction in the earnings multiple of its constituents and underperform on the other side of it due to the growth-hunting nature of investors. These funds make no claims of investor protection and the blame may lie on investors’ lack of due diligence if and when a position such as this doesn’t perform as planned.

For example, as stated above, USMV will rebalance semiannually into stocks that have experienced lower volatility than the broader indices in the recent past with no ability to adjust when the story changes. This leaves investors vulnerable to a swiftly changing environment. However, it can also prove harmful to the upside when certain areas of the market have vastly outperformed. But with higher volatility, these stocks are excluded from the fund and miss out on potential bull runs in certain sectors. The THOR Low Volatility Index Can Address Shortcomings. There are, however, solutions that address these shortcomings. The recently launched THOR Low Volatility Index takes a different approach in its definition of low volatility.

Rather than utilizing semiannual, backward-looking volatility metrics that fail during times of market stress, they use a much more frequent weekly rebalance of ten Sector SPDR ETF’s. THOR prides itself in lowering volatility for investors, especially on the downside, by utilizing AI to move into those sectors performing for investors and out of those which have underperformed. In addition, during times of severe downside stress, THOR has the ability to remove equity exposure, side-step potential large drawdowns, and re-enter when the market momentum has become more positive, including into those sectors which stand to benefit the most from a recovery.

Smoothing Out The Financial Rollercoaster.

THOR’s solution has proven to smooth out the ride for investors, giving them peace of mind that their assets can be protected, all the while taking advantage of those sectors poised to perform the strongest on the other side of a market stress event. THOR’s approach allows them to capitalize on strong market opportunities such as the energy sector in 2022. While other low volatility funds avoided it because of its higher-than-average volatility, THOR has taken advantage of its price appreciation until the sector became out of favor.

A Gain While Competitors Have Lost.

This method has allowed THOR to experience a gain of 1.6% since its September 13th inception through November 21st, while competitors USMV, SPLV and LGLV have lost 1.1%, 2.6% and 1.5%, respectively. In addition, SPY has lost 4.0% during the same time period. THOR’s view of low volatility differs from competitors in the belief that when investors purchase a low-volatility ETF, it should speak true to its name and offer the investor peace of mind during market stress.

Stability Should Be Peace of Mind.

When it’s actually needed most, low volatility should be top of mind for any investor searching for a stable solution. Typical low-vol solutions will simply underperform during typical bull market periods and especially underperform during extreme market stress and on the other side of it. However, THOR attempts to overcome this failed dynamic by allowing investors to experience index-like returns with much less standard deviation and downside capture (AKA stress), which is the guiding principle of what “low volatility” truly stands for.

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