Can 80/20 Replace 60/40?
A blogger at Seeking Alpha named Ploutos had an interesting post that pondered whether using low volatility, equity ETFs in an 80/20 mix with bonds could a substitute for a 60/40 portfolio comprised of SPDR S&P 500 (SPY) and iShares Barclays Aggregate Bond ETF (AGG) . By his work, the 80/20 had an average annual return of 10.18% which was 14 basis points behind 100% SPY on an annualized basis and 129 basis points ahead of 60/40, SPY/AGG. It was not clear what the time studied was.
Ploutos talked about the PowerShares S&P 500 Low Volatility ETF (SPLV) as a way to access low vol, large cap equities. He touched very briefly on PowerShares S&P Mid Cap Low Volatility ETF (XMLV) and PowerShares S&P Small Cap Low Volatility ETF (XSLV). The links in the symbols are to the ETF.com page for each fund.
Anecdotally, SPLV seems like the most common low volatility ETF, it was the first one to market but at $7.56 billion in AUM it is only half the size of the iShares Edge MSCI Min Vol USA ETF (USMV) which started trading a few months after SPLV.
In reading Ploutos' post it seemed like there was an assumption made that low volatility equity exposure occupies some sort of middle ground of volatility between market cap weighted equity and bond funds but that is not the case. According to ETFreplay the correlation of both SPLV and USMV to SPY for the last five years has been above 0.90 the vast majority of the time. Only lately has the correlation decreased probably due to the lack of FANG-type stocks in the low volatility funds. If an investment product, like a low volatility ETF, has a very high correlation to equities then it is a pretty good bet it is an equity proxy not a proxy for something else like bonds.
In that light, increasing exposure to equity proxies will of course increase the return. I would be wary of any type of study from the last few years as equities have gone straight up with ever decreasing volatility and these sorts of data points are going to get massively overhauled whenever the next bear market comes around.
There are a couple of different things to consider for anyone interested in following Ploutos' idea. The first is that SPLV, XMLV and XSLV make very large sector bets. I tend to think of 20% in one sector as something of a flashing yellow light. Tech has spent many years above 20% of the S&P 500, it was done in at 30% of the S&P 500 in the tech wreck. SPLV has 24% in financials and 20% each in utilities and industrials. XMLV has 31% in financials and 20% in utilities and XSLV has 47% in financials. This is easily mitigated depending on whether or what one of the funds might be paired with. A mix of four or five funds where the large weighting in utilities in SPLV is offset but the other funds being underweight or having no exposure wouldn't be a big deal but you need to look through to the funds' holdings and do some spreadsheet work.
Another thing to consider is the reduced allocation to fixed income. Equities are clearly expensive but historically, being expensive has never been a reliable predictor for when a market turns. We collectively understand what a bear market in equities looks like, we've had two of them since 2000. Not too many of us were around professionally for the last bear market in bonds in the late 1970's/early 1980's, it could be worse than an equity bear market. Shortening maturities and floating rate securities are good ways to avoid the full brunt of whatever might come in bonds but so too would increased equity exposure, like 80/20.
If more equity exposure is how you want to offset interest rate risk, and you think low volatility funds is the way to do it then I would say that USMV would be a better way to go for its better sector diversification. It is a little heavy in financials at 18% but that is the largest sector in the fund. Interestingly it has a higher beta than the S&P 500, per the iShares site but does have a lower standard deviation.
When the market turns I would prefer to reduce net long exposure as opposed to using low volatility ETFs in hopes they don't go down as much, it is not clear to me that they will work in the manner Ploutos might be implying.