Morningstar - Q3 2021 - 62

Strategies
Do Low-Volatility Funds Deliver?
It depends. Low volatility doesn't mean
no volatility, just less.
VOLATILITY
Ben Johnson
Low-volatility exchange-traded funds aim to
give investors a smoother ride in stock markets.
Being long stocks with less risk is a compelling
proposition. So, it's little surprise that these
funds have been popular. Over the trailing five
years through February 2020, investors poured a
combined $30.2 billion of their hard-earned
savings into U.S. large-cap ETFs that focus on
dialing down volatility. This represented
306% organic growth over that stretch. But the
early-2020 market meltdown and subsequent
rebound have put them to the test, and
many investors have gotten spooked. These funds
saw $18.1 billion in net outflows from March
2020 through May 2021.
Here, we'll look at how low-volatility ETFs
performed in the 2020 market downdraft and
subsequent recovery, examine the differences
among them, and see how investors
might use them to manage risk in their portfolios.
The Best of One World
Low-volatility strategies are at their best when
markets are at their worst. EXHIBIT 1 is a
relative wealth chart that plots the growth of the
MSCI USA Minimum Volatility Index divided
by the growth of the Morningstar US Market
Index. When the line slopes upward, the
minimum-volatility index is outperforming the
broad market index, and vice versa. The upward
spikes coinciding with the bursting of the
dot-com bubble, the global financial crisis, and
the COVID-19 pandemic are a testament to
the strategy's efficacy; it has taken some of the
sting out of stock market drawdowns.
62
Morningstar Q3 2021
But there are trade-offs. Investors can't have
the best of both worlds. Low-volatility strategies
tend to lag in bull markets. This is most
evident in the downward slope of the line that
spans the better part of the 1990s and more
recently in the post-pandemic-crisis rebound.
This is what investors in these strategies
signed up for. But after the most acute episode
of underperformance in the history of the
MSCI volatility benchmark, a lot of them clearly
aren't willing to suffer through it.
A year-plus of underperformance isn't an
indictment of these strategies. Over the long term,
investors in low-volatility funds are betting
that this trade-off between losing less on the
downside and not gaining as much on the
upside will result in marketlike returns with less
risk. The nearly three decades of performance
history illustrated in EXHIBIT 1 show that
it has generally been a solid bet-over a long
enough horizon.
Weathering the Storm
How did low-volatility ETFs weather the storm in
the first quarter of 2020? In a word: differently.
We currently assign Morningstar Analyst Ratings
to two of the 10 U.S. large-cap low-volatility
ETFs. Invesco S&P 500 Low Volatility ETF SPLV
is rated Neutral, and iShares MSCI USA Minimum
Volatility Factor ETF USMV is rated Silver.
During the pandemic-induced sell-off, USMV's
maximum drawdown (the depth of its decline
from its mid-February peak) was 33.1%.
SPLV's maximum drawdown was 36.3%. Gold-rated
iShares Core S&P Total U.S. Stock Market ETF
ITOT-a proxy for the broader U.S. market-
experienced a maximum drawdown of 35%.
USMV performed as expected during this episode;
SPLV did not. That said, investors should not
expect these funds to bat a thousand outperforming
the market each time it dips. The longer the
EXHIBIT 1
Best During the Worst Minimum-volatility strategies shine in times of
maximum volatility.
Growth of the MSCI USA Minimum Volatility Index Divided by
the Growth of the Morningstar US Market Index.
Relative Wealth
1.2%
Global Financial Crisis
COVID-19 Pandemic
0.79
Dot-Com Bubble Burst
0.7
0.8
0.9
1.0
1.1
0.6
05/28/1993
05/28/1999
05/28/2005
Source: Morningstar Direct. Data from May 28, 1993, through May 31, 2021.
05/28/2011
05/31/2021
https://www.morningstar.com/authors/680/ben-johnson

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