Friday, February 22, 2013
Low Volatility Funds
First of all, I absolutely love this blog and particularly enjoy reading about your perspective on the looming "bond bubble" and why investors should not fear it. I am curious if you have any thoughts on the growing popularity of "low volatility" funds such as SPLV. I am intrigued by the idea of fund that would potentially slightly underperform the S&P 500 in good years while outperforming in the down years. I think many investors are still scarred by the 2008-2009 crash and would like to take a more defensive approach when it comes to investing. What if someone were to replace a portion of their holdings in VTSAX with SPLV. Do you think there is any value in this approach if they wanted to minimize the down years? Thanks
Thank you for your kind words about my blog -- and my apologies for not posting much lately. Low volatility funds like ETFs SPLV and USMV are a very interesting development. First a couple of words about the composition of these funds. Although they may resemble large-cap value funds (most notably, by having higher-than-average dividend yield) they are instead composed of all sorts of large-cap stocks that have exhibited low volatility in the recent past. Many of these stocks happen to be value stocks, but as we'll see shortly the entirety of these funds is in no way value-oriented (at least not by traditional price/book measure of value).
SPLV uses Standard & Poors low volatility index and USMV uses MSCI minimum volatility index. The details of how the indices are constructed are involved. MSCI methodology calls for all industry sectors to be represented in roughly similar proportions as in the entire stock market. S&P methodology does not have such strict requirements resulting in a much less diversified set of stocks that are very heavy on utilities and consumer staples (aka "defensive" consumer stocks). There are a couple of other strikes against low volatility funds. They have (slightly) higher management costs and are also likely result in higher turnover and associated hidden frictional costs.
Let's first confirm that these low volatility funds do in fact provide stock-like returns at lower volatility:
Both SPLV and USMV have short histories, but their story checks out for the year and a half or so that they've been around. The blue line on the chart above is Vanguard's Total Stock Market fund (VTSMX) and the orange and green lines are SPLV and USMV respectively (with all dividends re-invested, which is the only way to compare investments, of course). SPLV and USMV have in fact provided returns roughly on par with the entirety of the stock market but at significantly lower volatility. So far so good.
The question then becomes whether it's realistic to expect low volatility funds to continue to provide market-level returns at much lower volatility? As with any question about the future there is no way to be absolutely sure, but looking at valuations I am strongly inclined to say that no, it's not realistic.
Before we jump to the numbers note that it is very important for an apples-to-apples comparison to use valuations from a single authority (e.g. Morningstar) when comparing different fund families funds because one company's valuations methodology can vary wildly from another. For example, iShares.com shows its S&P 500 fund, IVV, to have P/E of nearly 20 and P/B of 4.0 while Vanguard shows its S&P 500 fund, VOO, to have P/E of about 16 and P/B of 2.2. Since the two funds are all but identical, there is a clear disconnect in the methodologies the two companies use to come up with those numbers. But when we compare the same two funds on Morningstar, we find P/Es of 14.0 and 13.3 for IVV and VOO respectively and P/Bs of 2.0 for both -- all but identical, just as we would expect. We don't have to dig into the details of which one of these widely varying sets of numbers is the right one (and we probably wouldn't have enough information to decide anyway). But we do want to make sure we compare apples to apples, which is why we use Morningstar's figures and not iShares' or Vanguard's.
With that in mind, let's look at these funds' valuations using numbers found at Morningstar.com:
The above chart compares the valuations of SPLV, USMV with more traditional value and growth halves and the entirety of S&P 500 stocks (represented by three iShares ETFs). The top half shows actual numbers for 3 value-oriented and 3 growth-oriented measures. The bottom half ranks the 5 ETFs on those 6 measures and finds average ranking for each ETFs. The fund whose column is colored blue is most desirable -- it is either cheapest or fastest-growing. Then come green, yellow, orange, and finally red, representing the most expensive or slowest-growing fund.
What we find is that our low volatility funds are less value-y than value stocks and less growth-y than growth stocks. In other words low volaility funds are relatively expensive and relatively slow-growing compared to the entirety of the stock market. That's the price you pay for that low volatility.
Although SPLV and USMV seem likely to retain their low volatility going forward (though at least in case of SPLV I would be worried that the lack of diversification could eventually backfire when the specific industries -- especially utilities -- over-represented in that fund are hit unusually hard), it is in my opinion not realistic to expect them to match the returns of the broader stock market which is both priced cheaper and has historically grown faster.
That does not necessarily mean that these funds are obvious duds. Low volatility is, of course, highly desirable. Just understand that you are paying a price for that low volatility. If you do decide to invest in low volatility funds, based on what I saw preparing this post I would definitely go with USMV over SPLV. USMV has much better diversification, lower expense ratio, and its holdings appear to be less overpriced on valuations relative to the broader market.