Factor funds can be merciless. Aggressive momentum ones have long been the clear winners and defensive low-volatility ones the obvious losers.
The popular $22.6 billion Invesco S&P 500 Momentum exchange-traded fund has delivered a blistering 20% 10-year annualized return versus a modest 10.1% for the $24.1 billion iShares MSCI USA Min Vol Factor ETF and the S&P 500 index's 15.3%. Yet factors like growth, value, momentum, quality, and low volatility go in and out of style.
Low-volatility funds can make good diversifiers to bring the overall temperature of a momentum-driven portfolio down. Yet it's essential to understand the design of each fund, as they vary significantly.
The iShares MSCI USA Min Vol Factor ETF tracks the MSCI USA Minimum Volatility Index, which is a subset of the MSCI USA Index. The volatility index doesn't just hold the least-volatile stocks, but has guardrails requiring that no individual sector weighting differs too much from the parent index's weighting.
That means the ETF isn't skewed toward lower-volatility sectors, says Jay Jacobs, BlackRock's U.S. head of equity ETFs, but "resembles more of what you would expect in a broad market index." Like the broad market, the fund still has a large 32% weighting in tech stocks, albeit with an emphasis on less-volatile names and smaller position sizes. Amphenol and Microsoft, its two largest holdings, comprise only 1.6% each in the portfolio versus a 5.4% weighting in Microsoft and 0.3% in Amphenol in the MSCI USA index.
The $7 billion Invesco S&P 500 Low Volatility ETF holds the 100 stocks in the S&P 500 with the lowest volatility over the past 12 months. That leads to sector concentrations radically different from the tech-heavy S&P 500, with the fund recently having 27% in utilities, 24% in financial services, 17% in real estate, and 0% in tech stocks. This is a purer expression of the low-volatility factor, but the sector concentrations create different risks. For instance, a rising interest-rate environment hurts utilities.
Market regime shifts "can impact a volatility strategy, and sector diversification can help mitigate that," Jacobs says. "We're looking at lower volatility relative to the parent index, not just low volatility in isolation." Still, passively following a rules-based benchmark that rebalances its portfolio on a defined semiannual schedule-as iShares does-also has limitations. A significant market shift can occur between rebalances, for example.
The Vanguard U.S. Minimum Volatility ETF and Vanguard Global Minimum Volatility fund have similar sector weighting guardrails, yet because they are actively managed, they don't have a fixed rebalancing schedule. "We can adjust the portfolio when it's most needed," says Scott Rodemer, manager of the two funds. "When you get big dislocations in the market, we can be thoughtful about how to reorient the portfolio. We can invest in stocks that are low volatility today, and not what was represented as low vol by an index methodology from several months ago."
Further out on the actively managed spectrum are LSV US Managed Volatility and LSV Global Managed Volatility, which have greater sector weighting flexibility and combine the low volatility factor with a valuation-driven quantitative model for stock selection. (The two funds are tiny, with less than $50 million combined, but LSV runs $3 billion in institutional private accounts in largely identical low-vol styles.)
Manager Jason Karceski says LSV's quantitative research has found that historically, "cheap, healthy, low-vol stocks beat expensive low-vol stocks." LSV's two funds have indeed outperformed their low-vol factor peers in the past five years, though the U.S. one has lagged behind in the past 10.
Still, having a valuation discipline makes sense in a frothy market. For international stocks, consider the value-focused Franklin International Low Volatility High Dividend Index ETF, which has beaten 99% of its peers in the past five years. It should make a good diversifier today.
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