Investors Reject Minimum Volatility ETFs Despite Rising Market Turmoil

Stock market volatility has hit one of its highest levels in a decade, but so-called “minimum volatility” funds still can’t catch a break.

The once scorching investment thesis lasted two torrid years. Since the start of 2020, BlackRock’s iShares MSCI USA Min Vol Factor (USMV) exchange-traded fund with $27.4 billion in assets, the sector’s powerhouse, has returned just 13.6% , compared to 37.8% for the MSCI as a whole. The US index was not helped by the underexposure to technology stocks which fueled the market rally.

Worse still, the USMV has managed to grossly underestimate iShares’ equivalent ETFs that track investment “factors” such as momentum, quality, (small) size and even the widely derided value factor in the world. over the same period – although all of these also underperformed the returns of the broader US stock market.

Investors voted with their feet. Minimum volatility ETFs saw net outflows of more than $20 billion in 2020 and 2021, according to Morningstar data, reversing a decade of strong growth that resulted in inflows of $18.4 billion in 2019. The period included a huge spike in volatility during the Covid crash in March and April 2020.

The strategy’s global assets fell from a high of $71.3 billion at the end of 2019 to $56.4 billion, according to Morningstar, despite tailwinds from a market rally that sent stock prices higher. Americans by 40%.

And while it’s just the beginning, 2022 hasn’t started very well either, with new releases of $331 million. Even though the strategy’s underexposure to previously popular growth stocks is no longer a drag in an environment of increasingly belligerent central bank sentiment, the USMV failed to provide a defensive cushion.

It fell just as much as the broader US stock market – even as the much-maligned value factor shielded investors from the worst of the selloff.

“No customer has asked me questions about [minimum volatility]. It’s another anecdote that the flows aren’t hot,” said Karim Chedid, head of investment strategy for iShares in the Emea region.

The concept of minimum volatility is based on an anomaly first identified by economists Fischer Black and Myron Scholes in the 1960s, who discovered that the least volatile stock-based portfolios tended to outperform the market, perhaps be because investors were overpaying for more attractive stocks.

While in theory this should mean that min. outperform over the cycle, their inherently defensive nature – overweight consumer staples and boring utilities, underweight slicker tech and consumer discretionary stocks – should come into their own when investors are hungry for more. a degree of protection against the worst market turbulence.

However, in the three months since market volatility began to reach high levels in November, driven by a correction in previously enthusiastic tech stocks, there has been no sign of this edge emerging. .

Column chart of annual net flows to/from minimum volatility ETFs, globally (in billions of dollars) showing minimum interest

Some think it may just be a matter of time.

Minimum volatility is “an important tool. It’s classic insurance: you’re more likely to have [exposure] when you think things are more likely to go wrong,” said Andrew Jamieson, global head of ETF products at Citi.

“Markets have been pretty benign after March-April 2020. Since then there has been a strong economic recovery and stocks have done quite well. This year we had a tech sell-off and things are a little bumpy.

“We could start to see people coming back in the min vol. I think he has a future,” added Jamieson.

“As a long-term play [min vol funds] make a lot of sense. Although they suppress the upside and provide good downside protection, over the long term they slightly outperform. »

Matteo Andreetto, head of State Street Global Advisors’ SPDR ETF business in Europe, said following the market rally after March 2020, “we face more potential risk to returns”, with volatility “both from an economics and a market perspective, one of the biggest challenges.

“Minimum and low volatility could potentially be extremely popular,” he added.

But Eric Balchunas, senior ETF analyst at Bloomberg Intelligence, said low volatility “has got to be one of the easiest things to sell. It’s like the market, but less risky,” but “people have tried and it didn’t work.”

He thought investors were unlikely to return en masse to ETFs like the USMV, even if minimum volatility ETFs began to outperform.

“Once something stops working and people walk out of it, and then it starts working again, can you bring investors back?” Balchunas asked. “The money could come back if the regimes change and [funds] outperform, but it’s rare to get a second bite of the apple after investors turn away from a once high theft strategy.

Chedid instead attributed min vol’s lack of traction in recent months to the nature of the current market environment.

“Min vol is doing well against the backdrop of a more traditional defensive environment,” he said, like a period of weakening economic growth. “We have volatility in the market, but it’s not volatility on the back of growth fears,” he said.

Rather than minimal volatility per se, Andreetto said, SSGA was “focused on creating quality and value at the heart of [its] portfolios”, stocks that benefit from higher quality and more predictable earnings potentially exhibiting low volatility as a result.

BlackRock’s Chedid came to a similar conclusion.

“You have two types of stocks which are well positioned: value stocks which are effective hedges against inflation and quality stocks which have strong pricing power and are able to bear production costs and higher labor force,” he said.

“There is more interest in these areas than min vol. This is another type of volatility environment.

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