Friday, 25 July 2014

Low Volatility ETF Update - Are they performing as advertized?

In 2012 we introduced the newly launched category of low volatility equity ETFs that promised more stability and equal or better returns in comparison to standard index funds with holdings selected and weighted by market capitalization. A couple of years have passed, so let's see how they are performing.

Comparison Table - Low Vol ETFs vs Cap-Weight Benchmarks
(click to enlarge table image)

Low Vol performance mostly lags Cap-Weight ...
The green cells in our comparison table above show where the Cap-Weight ETFs have done better than their Low Vol counterparts. The green cells outnumber the yellow cells showing Low Vol superiority. It is interesting how consistent is the pattern of returns. In every single equity market around the world, Cap-Weight has higher returns for the year ending June 30th. But the tide seems to have turned since the beginning of 2014 - most of the Low Vol ETFs have pulled ahead Year-To-Date (YTD).

... and the reason is that Cap-Weight should win in a strong bull market
As we noted in the original post (and as reiterated in this excellent National Bank Financial January 2013 analysis of Low Vol ETFs), the main drawback of Low Vol strategies is likely performance lag in strong upward markets. That is what has been happening - returns in every world market have been wonderful recently - 14% to 28% 1-year total returns in the various global equity markets. The Low Vol returns have been very good too, just not quite as good.

More evidence of how good things have been recently shows in the columns for Reward to Volatility (Sharpe) Ratio and Volatility (standard deviation of returns). Sharpe ratios are very high - compare the 1-year numbers ranging from 0.6 up to 4.6 versus the 10-year averages of 0.4 and 0.5. Historical long term Sharpe ratio figures across many equity markets cited in the 2012 Credit Suisse Global Investment Returns Yearbook (see Fig.4 on page 19) range from 0.1 to 0.7. We have been living in unusually good and stable times for the last few years. Volatility itself is also very low compared to past longer term averages. Equity volatility below 10 is well below the usual high-teen or greater long term average (see Tables 1 and 2 on page 22 of Credit Suisse). The result is that in several cases, the Cap-Weight ETF benchmarks actually display lower volatility than the Low Vol ETFs which are specifically designed to be lower volatility.

When markets go sour again, that will be the real test of Low Vol ETFs
It is perhaps obvious to say it but the current equity party will end - market volatility will return and large market drops will happen. There's no reason to think the history of markets will not be repeated and equities will not exhibit considerable volatility in future. The only thing we don't know is exactly when that will happen. That is when we will see how much the Low Vol ETFs limit the downside drop and the volatility, perhaps proving their worth with better risk-adjusted (higher Sharpe ratio) and total returns.

We investors must decide whether to wait another five or ten years for definitive proof to emerge to substantiate the benefits of actual ETFs that attempt to capture results shown in academic research and backtests. Waiting means possibly missing out on Low Vol benefits ... or missing out on Low Vol disappointment if they really do not pan out.

As far as what other investors are doing, so far, the net asset figures of the various ETFs in our table show that Low Vol has caught on mainly in the USA. In Canada, only BMO's low vol version has attracted substantial investor money.

Disclosure: This blogger owns shares of the BMO Low Volatility Canadian Equity ETF (TSX symbol: ZLB).

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

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