The Low Volatility Dilemma

Where the strategy trumps the factor.

My buddy Phil Bak (@philbak1 on Twitter) who as an NYSE employee helped with the listing of the RRGR ETF that I managed for a while and who has since gone on to launch the ETF startup Exponential ETFs and become a thought leader in the ETF space had a thought provoking Tweet;

The low vol trade is super crowded. Like, nearing a breaking point level of crowded.

When I asked, he said he meant low volatility ETFs which is of course a popular niche and he also mentioned that the inclusion of gold mining stocks in some volatility funds means that one way or another, the popularity has lead to a distortion. For example, the largest holding in the iShares Edge MSCI US Min Volatility ETF (USMV) is Newmont Goldcorp (NEM) at 1.75%.

Low volatility funds have become extremely popular regardless of whether Phil turns out to be right. There's research out there that says low volatility outperforms market cap weighting which would account for the popularity of the strategy; wait, I can get better returns with less volatility? You can decide for yourself whether that stands up and if it does, how then best to apply it.

There are a lot of low volatility funds out there, 14 by my count targeting domestic equities, five of which have more than $800 million in AUM. It is important to dig into what any fund you might buy actually does. Invesco S&P 500 Low Volatility ETF (SPLV) owns the 100 least volatile stocks in the S&P 500 and so has a couple of massive sector weightings but that has always been the case for this fund as I wrote about for TheStreet.com when it launched. USMV is another big one but it has a different strategy it tries to optimize the portfolio to achieve a low volatility result. To explain what that means as an extreme example, a low volatility result could be created with the two most volatile stocks in the US market if they had a negative correlation through the blending of the two. USMV blends its holdings together to hopefully deliver a low volatility result which might account for it owning NEM and some other names that clearly have higher volatility profiles.

The blending of volatility profiles to target a specific result has long fascinated me and in part describes some of what I do in client accounts. I write all the time about layering in alternatives like BTAL, MERFX, TAIL, PTLC or inverse funds to manage the volatility of the overall portfolio. When the S&P 500 is below its 200 day moving average (DMA) I want reduce the portfolio's volatility with tools like the ones just mentioned. I think that makes more sense than a permanent, large allocation to a fund targeting the volatility factor, especially give the manner in which narrower based alternatives have evolved. SPLV and USMV should be less volatile than the broad market. I don't want to rely on should be because should be doesn't equal must be.

Low volatility definitely appeals to me but managing it more directly appeals even more.

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