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 analyzes the underlying portfolio holdings and discovers some interesting facts.
Using Style Research EnterpriseTM, we analyzed 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
The chart below shows the active sector weights versus the benchmark for both products using holdings as of end June 2016.
SPLV clearly has more significant active sector differences than USMV. Given the intention to bias to low volatility, it is no surprise that both products are overweight Utilities and Consumer Staples and underweight Info Tech. However, SPLV has 43.6% in Utilities and Consumer Staples versus only 24.2% for USMV. Overall, USMV has a predicted tracking error of 2.6% per annum versus the Russell 1000 index versus 4.5% 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 SkylineTM, starting with the iShares USMV fund.
Style TiltsTM become very significant around +/-2 so while the tilts to Low Beta and High Momentum certainly stand out, the negative biases to low Value, low Size, and low Foreign Sales are also significant. The -8.0 tilt to market beta is an obvious and confirming proof statement of the stated low volatility intention of USMV. However, Medium Term Momentum (12 months) and Short Term Momentum (weighted to around three months) confirm that the stocks currently held in USMV have had much stronger returns than the benchmark (21.7% versus 8.3%) over the 12 months. That’s great for past performance but how are these stocks positioned now looking forward?
The chart below shows how the Momentum Style TiltTM has changed in USMV over the past three years.
This style exposure drift in Momentum naturally would put some investors on alert for reversal risk. Interestingly, the positive bias to the IBES 1Yr forecasted revisions factor 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.
For example, the 3-year chart below shows how Earnings Yield and Cash Flow Yield tilts have fallen to become significantly more expensive, especially in the past year. Has this “Smart” investment become overpriced?
Now let’s look at the Style SkylineTM below for the PowerShares SPLV fund:
There are striking similarities in the type of stocks being selected by iShares and PowerShares for their low vol products. Beyond the clear corroboration of low volatility from the low beta tilt in SPLV, we can also see other similar style signals from low Value, low Size, high Momentum, and low Foreign Sales.
Conclusion: Low Vol now Expensive with High Momentum
For both USMV and SPLV, the graphic portrayal of expensive valuations, coupled with high momentum, also explains 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.