ETF Research & Solutions

So far in 2016, we’ve seen a large amount of net inflows into minimum-volatility ETFs as investors seek shelter in lower-risk stocks. These smart beta ETFs are designed to target the factor premium that has been attributable to favoring lower-risks stocks over their higher-risk counterparts.

Recent press, articles, and whitepapers have sharply criticized the minimum-volatility trade, and some have said that the higher valuations associated with these types of stocks are evidence of overcrowding by investors. This type of behavior suggests the premium investors harvest for owning such securities is likely to come tumbling down sooner rather than later.

Like all investment strategies, minimum volatility cycles through outperformance and subsequent underperformance over periods of time. Based on the conditions described above, should investors be thinking about rotating back out of minimum-volatility ETFs?

More and more investors are buying “factor” based strategies which invest using measures like valuation and low volatility, but the most popular strategies are applying factors in the wrong way. Strategies should be built for alpha, not scale—but the asset management industry has gone in the opposite direction.
Most factor-based strategies—commonly called Smart Beta—have hundreds of holdings and high overlap with their market benchmark. The far more powerful way to apply factors is to use them first to avoid large chunks of the market and then build more differentiated portfolios of stocks with only the best overall factor profiles. While not as scale-able as smart beta, this alpha-oriented approach has led to much better results for investors.

Indexes are affected and changed by asset flows into strategies which target those indexes. This is true when hundreds of billions of dollars seek low price-to-book strategies, and for the entire market as a whole. Fund flows affect everything, especially when those flows have T after them. To this point, this has worked in one direction, for the most part. Portfolios with decent valuations, by historical standards, are only achievable today through portfolios that are very different from the S&P 500. Costs are very important. But there are management fees and there are valuation multiples. At the very least, I urge you to consider both.