Stock market volatility has spiked to one of its highest levels for a decade, yet so-called “minimum volatility” funds still cannot get a break.
The once-hot investment thesis has endured a torrid two years. Since the start of 2020, BlackRock’s iShares MSCI USA Min Vol Factor exchange traded fund (USMV), with $27.4bn of assets the powerhouse of the sector, has eked out a return of just 13.6 per cent, versus 37.8 per cent for the broad MSCI USA index, not helped by under exposure to the technology stocks that fuelled the market’s rally.
Worse still, USMV has managed to sharply undershoot iShares’ equivalent ETFs tracking investment “factors” such as momentum, quality, (small) size and even the widely derided value factor over the same period — even though all these have also fallen short of the returns of the wider US stock market.
Investors have voted with their feet. Minimum volatility ETFs suffered net outflows of more than $20bn in 2020 and 2021, according to data from Morningstar, reversing a decade of strong growth that culminated in inflows of $18.4bn in 2019. The period included a huge spike in volatility during the Covid crash in March and April 2020.
The strategy’s global assets have sunk from a peak of $71.3bn at the end of 2019 to $56.4bn, according to Morningstar, despite the tailwind of a market rally that has pushed US stock prices up 40 per cent.
And even though it is early days, 2022 has not started off too well either, with further outflows of $331mn. Even though the strategy’s underexposure to previously in-vogue growth stocks is no longer a drag in an environment of increasingly hawkish central bank sentiment, USMV has failed to provide a defensive cushion.
It has fallen just as much as the broader US stock market — even as the much-maligned value factor has shielded investors from the worst of the sell-off.
“No client has asked me about [minimum volatility]. It’s another anecdote that the flows are not hot,” said Karim Chedid, head of investment strategy for iShares in the Emea region.
The concept of minimum volatility is based on an anomaly first identified by economists Fischer Black and Myron Scholes in the 1960s who found that portfolios based on the least volatile stocks tended to outperform the market, possibly because investors overpay for more exciting stocks.
While, in theory, this should mean min vol strategies outperform over the cycle, their inherently defensive nature — overweight dull consumer staples and utilities, underweight more racy technology and consumer discretionary stocks — might be expected to come into its own when investors crave a degree of protection from the worst of the market ructions.
However, in the three months since market volatility started to hit elevated levels in November, led by a correction in previously gung-ho tech stocks, there are no signs of this advantage emerging.
Some believe it might only be a matter of time, however.
Minimum volatility is “an important tool. It’s a classic insurance policy: you are more likely to have [exposure] when you think things are more likely to go wrong,” said Andrew Jamieson, global head of ETF product at Citi.
“The markets have been quite benign post March-April 2020. Since then there has been a strong economic recovery and stocks have done quite well. This year we have had a tech sell-off and things are a bit bumpy.
“We could start to see people coming back into min vol. I think it has got a future,” Jamieson added.
“As a long-term play [min vol funds] make a lot of sense. Although they suppress the upside and give good downside protection, over the long term they slightly outperform.”
Matteo Andreetto, head of State Street Global Advisors’ SPDR ETF business in Europe, said that in the wake of the post-March 2020 market rally, “we are facing more potential risk to returns”, with volatility “both from an economy and a market point of view, one of the biggest challenges.
“Min and low volatility could potentially be extremely popular,” he added.
But Eric Balchunas, senior ETF analyst at Bloomberg Intelligence, said low volatility “has got to be one of the easiest things to sell. It’s like the market, but lower risk,” but “people tried it and it didn’t work out”.
He thought it unlikely that investors would return en masse to the likes of USMV, even if minimum volatility ETFs did start to outperform.
“Once something stops working and people move out of it, and then it starts working again, can you get investors back?” Balchunas asked. “Money could return if regimes shift and [funds] outperform, yet it’s rare to get a second bite at the apple after investors sour on a once-high flying strategy.”
Chedid instead attributed min vol’s lack of traction in recent months to the nature of the current market environment.
“Min vol does well in the context of a more traditional defensive environment,” he said, such as a period of weakening economic growth. “We have market volatility but it’s not volatility on the back of growth fears,” he said.
Rather than minimum volatility per se, Andreetto said, SSGA was “focused on building quality and value within the core of [its] portfolios”, with stocks that enjoy higher quality, more predictable earnings potentially exhibiting low volatility as a result.
BlackRock’s Chedid came to a similar conclusion.
“You have two types of stocks that are well-positioned: value stocks that are effective inflation hedges and quality stocks that have strong pricing power and are able to withstand higher input and labour costs,” he said.
“There is more interest in these areas than min vol. It’s a different type of volatility environment.”
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