Morningstar Magazine - October/November 2016 - 28

Dispatches EXHIBIT 1 Steady Flows Flows into iShares Edge MSCI Minimum Volatility USA have been pushing the prices of the underlying stocks higher, making it look richly valued compared with iShares Core S&P Total US Stock Market. 10 8 10 6 8 4 6 2 4 0 2 -2 0 has managed to eke out marginally positive returns at best from current valuation levels and, more often than not, has wound up declining in value during the following three-year period. USMV Trailing 12-Month Flows ($ Bil) Ratio of USMV P/E to ITOT P/E USMV Trailing 12-Month Flows ($ Bil) 1.3 Ratio of USMV P/E to ITOT P/E 1.2 1.3 1.1 1.2 1.0 1.1 0.9 1.0 11/2012 11/2013 Source: Morningstar. Data from 11/2012-07/2016. -2 11/2012 11/2013 11/2014 11/2015 0.8 0.9 11/2014 11/2015 0.8 EXHIBIT 2 Disappointing Results Ahead? As the price/cash earnings ratio for MSCI USA Subsequent Minimum Volatility Index has increased, ensuing returns have 3-Year beenAnnualized lower. Return (%) 30 Subsequent 3-Year Annualized Return (%) 30 15 15 0 7 8 9 10 11 Beginning Price/Cash Earnings Ratio 12 13 14 15 16 17 0 -15 7 8 9 10 11 Beginning Price/Cash Earnings Ratio 12 13 14 15 16 17 -15 Source: Morningstar, MSCI, Data from 06/30/1994-07/31/2016. versus ITOT. When it is less than 1 USMV is relatively cheap. Clearly, USMV has been getting relatively rich versus ITOT since the second half of 2013. The ratio of the two funds' P/E ratios was 0.9 as of the end of August 2013-the last time it was below 1. As of the end of July, the ratio stood at 1.24. USMV's valuation has also gotten richer in absolute terms. At the end of August 2013, the fund's trailing 12-month P/E was 1 .05. As of the end of July, it had expanded to 23.9 . What does this mean for future returns? If history 28 Morningstar October/November 2016 is any guide, investors should expect them to be muted at best. E X H I B I T 2 shows the historical relationship between the beginning value of the MSCI USA Minimum Volatility Index's price/ cash earnings ratio and subsequent three-year annualized returns. The pattern is clear: The richer the beginning valuation, the lower the ensuing return. As of the end of July, the index's price/cash earnings ratio was 15.4-its highestever level. (Note that the index was launched on June 2 2008. This article also referenced a data set that includes back-tested data that begins in June 1994.) Dating back to June 1994, the index hile low- olatilit strategies a er well o er superior long-term risk-adjusted returns relative to a broad, market-capitalization-weighted index- valuations matter. These strategies' popularity may have pushed valuations to levels where it will take a long time for this proposition to pan out. Ben Johnson,CFA, is director of global ETF research for Morningstar. Where Do Bank-Loan Funds Go From Here? These are interesting times for bank-loan portfolio managers. Bank-loan funds have proved to be especially prone to whipsawing views about the path of interest rates. Like high-yield bonds, ban loans also re erred to as oating-rate loans are usually issued by below-investment-grade companies, so credit risk is still high, and returns typically display a higher correlation to equities than traditionally safe-haven bonds like Treasuries. If the economy is weak or in recession, this asset class may not perform well. For example, the bank-loan Morningstar category fell 29.8% in 2008. (It also surged by 41.8% in 2009.) However, bank loans are higher in the capital structure compared with traditional corporate bonds and are also secured by assets of the issuing r whereas bonds are t icall unsecured. In other words, in the event o ban ru tc ban loans co e rst thus making them safer bets with regard to credit risk. This means that bank loans should hold up relatively well compared with high-yield corporate bonds in the case of a default or general economic weakness, even though they may still experience losses. There's a strong case that bank loans can help insulate investors from the price declines that traditional bonds would experience when

Table of Contents for the Digital Edition of Morningstar Magazine - October/November 2016