Style Research’s Bernie Nelson (pictured) asks how concerned should investors be about the likelihood and impacts of the crowd leaving?
Low Volatility ETFs have certainly been popular and some would even say the strategy has become crowded over the past year, with large inflows and strong performance. But these products are delivering more than just low volatility.
Style Research analysed the underlying portfolio holdings and discovers some interesting facts. Using Style Research Enterprise, we analysed two popular Low Volatility products, the iShares Edge MSCI Min Vol USA Index ETF (USMV) and the PowerShares S&P 500 Low Volatility Portfolio (SPLV). In order to provide an apples-to-apples comparison of these two products, we analyzed them both against the Russell 1000 index, providing a neutral viewpoint away from their respective indices.
Same Style, Different Approaches
Given the intention to bias to low volatility, it should be no surprise that both products are overweight Utilities and Consumer Staples and underweight Info Tech. However, SPLV has 43.6 per cent in Utilities and Consumer Staples versus only 24.2 per cent for USMV. Overall, USMV has a predicted tracking error of 2.6 per cent per annum versus the Russell 1000 index versus 4.5 per cent per annum for SPLV. The results are almost identical if we select the S&P500 as the common benchmark. These differences are significant.
Now let’s zoom in on some key style insights for both products using the Style Skyline, with the iShares USMV fund. USMV has a very significant tilt to Low Beta, which should come as no surprise, confirming the stated low volatility intention of USMV. However the fund also has significant tilts to High Momentum, Low Value, Low Size, and Low Foreign Sales.
The fund’s Medium Term Momentum (12 months) confirms that the stocks currently held in USMV have had much stronger returns than the benchmark (21.7 per cent versus 8.3 per cent over the 12 months to end June 2016). That’s great for past performance but how are these stocks positioned now looking forward?
The fund’s Medium Term Momentum Style Tilt has increased significantly over the past three years. This style exposure drift in Momentum naturally would put some investors on alert for reversal risk. Interestingly, the fund also has a positive bias to the IBES 1Yr forecasted earnings estimate revisions, which tells us that sell-side analysts are still revising their forecasts up more than down for these stocks compared with the benchmark average. This latter signal may explain why Low Vol stocks are continuing to perform in tandem with a possible crowding effect.
Finally, our analysis shows that USMV is significantly more expensive than the benchmark as measured by low Book-to-Price, low Earnings Yield (high P/E), and low Cash Flow Yield. This amplifies the recent concerns from Rob Arnott of Research Affiliates and others that Smart Beta products may be overvalued as a result of their popularity. Over the past three years Earnings Yield and Cash Flow Yield Style Tilts have fallen to become significantly more expensive, and especially so in the past year. Has this “smart” investment become overpriced?
The Style Research analysis of the PowerShares SPLV fund shows some striking similarities to USMV Beyond another clear corroboration of low volatility from a Low Beta style tilt in SPLV, the style signals are also similar to Low Value, Low Size, High Momentum, and Low Foreign Sales.
Conclusion: Low Vol now Expensive with High Momentum
For both USMV and SPLV, current expensive valuations, coupled with high momentum, can explain why some are now very nervous about the reversal risk of Low Volatility products. The hot but expensive stocks in these ETFs may be facing a large correction.
Fund performance can be affected by a lot more than just the style described in the fund name. A more rigorous institutional-strength evaluation of ETFs, including Smart Beta, is now available to investors who need to see the full picture of what they are buying.