What is a Minimum Volatility ETF?
February 7, 2017
The popularity of strategic-beta ETFs has risen sharply over the past few years. One of the fastest growing segments are those exchange traded funds which aim to reduce risk within an equity portfolio; called low-volatility and min-volatility funds. From the launch of the first minimum volatility ETF by Amundi in 2009, the total number of products has mushroomed to almost 70 globally, according to Morningstar’s classification, amassing nearly $45 billion of assets under management.
In November, Morningstar unveiled Analyst Ratings for over 250 ETFs globally, including some of the largest risk-reducing ETFs. Of these, thirteen have been rated either Silver or Bronze.
The Merits of Medalist Risk-Reducing Equity ETFs
Most of the ETFs track indices belonging to the MSCI Minimum Volatility index family. Each MSCI Min Vol index aims to construct the least volatile portfolio possible with stocks from the parent index, under a set of constraints to ensure diversification. Because stocks should have the least level of correlation between each other, the strategy doesn’t just target the least-volatile stocks. The portfolio may also comprise average- to high-volatility stocks.
In contrast, the low-volatility portfolio offered by PowerShares holds only the least-volatile stocks. Each quarter, the fund ranks the constituents of the S&P 500 by their volatility during the past 12 months and targets the least volatile 100. It then weighs them according to the inverse of their volatility, so that the least volatile stock receives the largest weighting in the portfolio. Unlike the MSCI Minimum Volatility index family, the S&P 500 Low Volatility index doesn’t consider how stocks in the portfolio interact with each other. It doesn’t constrain its sector weightings of turnover either, which could result in large sector tilts that change over time.
We see merit in both strategies as both should offer a smoother ride and better risk/reward profile over the long term than their market-cap weighted parent benchmarks and most of their peers. However, these strategies are cyclical in nature and may experience periods of underperformance.
So far, both strategies have delivered on their promises. Over the past three, five, and 10-year periods, they have achieved a reduction in the realised volatility of around 20-40% against the broad market. Moreover, when compared to category peers, these ETFs have been amongst the top performers on both a risk-adjusted and non-adjusted basis.
This performance has attracted even more investors into risk-reducing strategies over the past three years, leaving some wondering whether valuation levels haven’t become stretched. As with any investment, placing a position at a high valuation point may mean that one would have to wait longer to harvest the potential benefits.
Source: Morningstar. Dimitar Boyadzhiev | 07/02/2017
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