The growth of low-volatility factor investing in U.S. equities has been explosive in recent years, as shown by the proliferation of strategies that seek to limit downside risk through overweight exposure to stocks that have historically been less volatile than the broad market. The two largest exchange-traded funds that employ low-volatility strategies have seen their assets under management increase more than sevenfold over a five-year period, growing from a combined $2.8 billion in 2012 to nearly $20.7 billion today.1
The appeal of such strategies over much of the current economic cycle may reflect investors still holding emotional baggage from the large losses sustained in the financial crisis of 2008–2009. In the conversations we routinely hold with our asset management network, we have discussed the recent growth of low-volatility strategies and the relative merits of the factor given the evolving market backdrop. The shared perspectives that we have been receiving suggest that the low-volatility factor may be a less than ideal implementation tool to navigate today’s changing market dynamics.
A mixed record
Looking at recent performance, there appears to be some value in the strategies, if an investor’s sole focus is to seek downside protection in meaningful equity pullbacks driven by risk-off environments. Our research focused on drawdowns of the S&P 500 Index and the MSCI USA Minimum Volatility Index over the five-year period ended August 25, 2017. Over the course of market declines in the fall of 2015 and early 2016, the drawdowns of the low-volatility index were significantly smaller than those of the S&P 500. However, the low-volatility strategy failed to offer downside protection in a more recent drawdown in the late summer and early fall of 2016. In that period leading up to the U.S. presidential election, the S&P 500 experienced a 12-week downturn with a maximum drawdown of –4.2%. The low-volatility index sustained a downturn that lasted much longer and was significantly deeper: 30 weeks, with a maximum drawdown of –6.9%.2
This surprising result begs the question, “How could a low-volatility stock sustain a greater and longer drawdown than the broader market?” Based on our conversations with our network—primarily made up of asset managers who pursue bottom-up approaches to security selection—it appears that there are two reasons to explain this apparent anomaly. One concerns the backdrop of the macroeconomic environment during this period; the other involves differences in sector weightings of the low-volatility index relative to the broad market.
Over the period of the drawdown, U.S. Treasury bond yields rose in a market shaped by what many participants called the reflation trade—yields rising on expectations of accelerating economic growth and an accompanying increase in inflation. In such a market, fixed-income yields can significantly influence equity performance, particularly in yield-oriented sectors. Among the largest overweights in the low-volatility factor index relative to the S&P 500 are the utilities and consumer staples sectors, with an overweight of approximately 4% to 5% in each.3 These segments of the market are often the most negatively affected by rising bond yields, and the low-volatility index’s higher exposure to these sectors in an environment of rising bond yields was a key driver of the deeper drawdown. Coincidentally, our network currently maintains a negative consensus view of these sectors, as they have recently traded at higher relative valuations than the broader market and may be more susceptible to headwinds in a rising yield environment.
Stay alert for reflation
Over much of 2017, the reflation trade has been dormant, as inflation has been muted and bond yields have fallen. Heading into late 2017 and early 2018, our network views a re-emergence of the reflation trade as one scenario that could very well play out in coming months. Network members are keeping a close eye on catalysts that could trigger a comeback for the reflation trade, such as strengthening economic growth, the potential for tax reform, and other forms of fiscal stimulus. While low-volatility strategies have shown their value in helping to mitigate losses during meaningful equity drawdowns, other macro variables at play suggest that investors could be in for a bumpier ride than they had anticipated.
1 Morningstar Direct, iShares Edge MSCI Minimum Volatility USA ETF (USMV), and PowerShares S&P 500 Low Volatility Portfolio (SPLV), as of 9/28/17.
2 FactSet, as of 9/28/17.
3 FactSet, MSCI Inc., S&P Dow Jones Indices, as of 9/28/17.