Investors have been looking into low-volatility exchange traded funds that limit downside risk and still maintain some upside potential as headwinds increase toward the end of the business cycle, but the strategy is beginning to look pricey.
Over the past year, the iShares MSCI USA Minimum Volatility ETF (Cboe: USMV) and Invesco S&P 500 Low Volatility Portfolio (NYSEArca: SPLV) were among the more popular ETF plays, attracting $8.7 billion and $2.4 billion in net inflows, according to ETFdb data.
The low-volatility investment style beloved by quants has experienced a wave of inflows over 10 consecutive months on rising demand for safety, Bloomberg reports.
However, the heightened demand for these types of safety plays has caused U.S. companies with muted price swings to trade at their highest premium over global peers since February 2018.
“Those stocks that are technically defined as low volatility that have a low realized volatility are expensive,” the portfolio manager for high-income equities at TCW Group Inc., told Bloomberg.
The defensive low-volatility strategy has appeared attractive the current market mired with trade and liquidity concerns, easing profit growth and economic woes, with volatility recently spiking in response to another round of trade fears.
“Going forward, we all expect there to be much more volatility in the markets than there potentially has been in the past,” Michael Hunstad, head of quantitative strategies at Northern Trust Asset Management, told Bloomberg. “So it’s a very good time to think about de-risking even if you’re potentially cutting some of that upside participation.”
The low-volatility ETFs are factor-based strategies that tilt toward companies with a propensity for lower volatility. Different issuers and index providers arrive at a basket of low volatility stocks in varying fashions.
For example, SPLV holds the 100 S&P 500 members with the lowest trailing 12-month volatility.
USMV uses a different approach, somewhat more complex approach relative to traditional low volatility products, but has its advantages as well. Its risk model puts greater emphasis on more-recent data, which may be more predictive of future risk.
For more information on alternative index-based strategies, visit our smart beta category.