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7 Questions to Consider When Evaluating Low Volatility ETFs

StratiFi Technologies Inc

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I recently sat down with Justin Lowry of Global Beta Advisors for a webinar to discuss the embedded risks in Low Volatility and Dividend Strategies that are overlooked and may be even misunderstood.

If you invested in low volatility ETFs like SPLV, USMV (iShares Edge MSCI Min Vol USA ETF has over $25 billion as of 03/18/2021) or are interested in them to reduce risk, then you’ll want to read on to get some good insights on how to correctly understand the risk of low volatility strategies and use them in your portfolio.

Justin Lowry has over a decade of experience managing several billion dollars in such strategies so he knows a few things. Justin spoke about the importance of discipline in investing, something he learned and practiced through his years of investing in the markets especially at the height of the Global Financial Crisis in 2008 and he’s applying the same discipline at Global Beta. They provides a suite of factors to investors looking for a diversified set of exposures to the market with one important idea in mind…revenue.

In this blog post, I’ll cover the key points he shared during our hour long conversation. For more details and an insightful discussion with Justin Lowry, please check out the video.

Here are the 7 main questions, I asked Justin:

  1. What are low volatility ETFs?
  2. Why did some of the low volatility ETFs fail to reduce risk in Q1 of 2020?
  3. How do you look out for embedded risks in low volatility ETFs?
  4. If historical volatility isn’t the right measure to understand the risk in the low volatility ETFs, what is?
  5. Looking forward which environment are advantages/disadvantageous for Low Vol ETFs?
  6. Should Low Volatility ETFs be a core part of an investor’s portfolio?
  7. What Low Volatility ETFs can one invest in other than SPLV, USMV?

 So let’s get into the details:

Lodha: “What are Low Volatility ETFs?”

Lowry: “A low volatility ETF or minimum volatility ETF invests in stocks in its benchmark index like the S&P 500 with the lowest/minimum volatility. 

Basically, these strategies are looking at the historical trailing volatility (standard deviation) to find the stocks to hold. If the market volatility increase you’d expect these ETFs to reduce risk but in the recent market crash in 2020, some of these low volatility strategies failed to protect investors.”

Lodha: “Why did some of the Low Volatility ETFs fail to reduce risk in Q1 of 2020?”

Lowry: Tail risk.

Low Volatility ETFs were getting very popular and were overcrowded. Several ETFs were buying the same stocks in the same sectors like Utility at the same time. When the pandemic hit, people sold those stocks at the same time and these low volatility ETFs suffered. Looking at just standard deviation doesn’t tell you what would happen if everything went down.

Interestingly, from May of 2011 (when most Low Volatility ETFs were launched) to Feb of 2020 on average the S&P 500 Low Volatility Index was trading at a 3.5% discount relative to S&P 500 but by the time we got to March 2020, that changed to a 21% premium. Why did that happen?

Investors were piling in similar stocks and sectors. There was a lot of influx in these kinds of funds and everyone piled in at the same time. The market can become a machine that carries everything with it when it goes down.”

Lodha: “How do you understand the risk of Low Volatility ETFs?”

Lowry: “Most of these Low Volatility ETFs use standard deviation as their metric to pick stocks that go into the fund but that can be misleading because the current price action or in other words, what’s really going on in the market may not be picked up in the standard deviation calculation so it’s important to understand where things are priced relative to their historical norm.

The importance of Price to Sales Ratio. Look at price to sales. If price to sales is above a certain ratio you should be careful. Because that could indicate that people are buying into same stocks and its drifting things away from the norm until they mean revert.

In the chart below, we can see that when Price to Sales Ratio (P/S) is above 3.5, the 5 year and 10 year forward looking returns for the Growth Index were negative.

-Source: Global Beta Advisors Performance measured from 03/31/95 to 12/31/20.

Lodha: “If historical volatility isn’t the right measure to understand the risk in the current market, what is?”

Lowry: Look at beta relative to the market and how that is changing will help investors in finding securities that have lower correlation and true downside protection. And, don’t forget to look at revenue of the companies you are investing in. This could give you not only better downside protection but also gives some upside potential.

At StratiFi, we look at a variety of different factors to understand risk. You can read more here.

Lodha: “Looking forward which environment are advantages/disadvantageous for Low Vol ETFs?

Lowry: “Higher inflation environments are beneficial for Low Vol ETFs. Momentum environments on the downside are disadvantages for Low Vol ETFs because people pile in growth/value etc., and then the markets crash hard.”

Lodha: “Should Low Volatility ETFs be a core part of an investor’s portfolio?”

Lowry: “If done correctly, allocation to low volatility ETFs can help investors in creating a robust portfolio. Mean reversions do happen and if investors do include low volatility ETFs they can protect portfolios from some whiplash.”

Lodha: “What Low Volatility ETFs can one invest in other than SPLV, USMV?”

Justin Lowry at Global Beta has some options for you. Check out Global Beta Advisors to find out more. You can run the Global Beta funds through StratiFi’s PRISM Rating system to understand how they manage tail risk.

There are other choices you can find on ETF Database.

We are not recommending any particular funds to you. Our goal is to empower the investors with more information and give them the tools to make better decisions. Please be sure to understand the hidden and embedded risks in these ETFs.

Akhil Lodha
Akhil Lodha Author
Co-founder & CEO StratiFi Technologies

Building the industry standard for understanding portfolio risk through cutting- edge technology at Stratifi.

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