Investors Quickly Tired of Low Volatility ETFs

Over the years, low volatility exchange-traded funds (ETFs) have proven popular with investors, and these products have been important drivers of the smart beta phenomenon. That does not mean investors are continually flocking to low volatility funds. Actually, data suggest that ETFs such as the iShares Edge MSCI Min Vol USA ETF (USMV) and the Invesco S&P 500 Low Volatility Porftolio (SPLV), the two largest U.S.-focused low volatility ETFs, have been plagued by outflows over the past year. Part of the reason why investors are departing "low vol" funds could be tied to frustration regarding these products lagging the broader market.

"Generally, this is what investors should expect," said Morningstar in a recent note. "Low-volatility portfolios tend to offer above-average downside protection in exchange for below-average upside participation. Over the long term, this should translate to better risk-adjusted (not absolute) returns for investors in low-volatility stocks." (See also: How Low Volatility ETFs Can Enhance Your Success.)

Over the past 12 months, SPLV and USMV have generated an average return of 8.3%, barely more than half the 16.2% returned by the S&P 500 over the same period. As Morningstar notes, low volatility ETFs are designed to perform less poorly during market downturns while not participating in all of the upside delivered during a bull market.

Still, the margin by which SPLV and USMV are lagging the S&P 500 over the past year could be the catalyst for the departures from those ETFs. Over the past year, USMV has lost $2.44 billion in assets. SPLV has shed $1.36 billion in assets over the past 12 months, more than any other Invesco ETF during that period, according to issuer data. (See also: Do Low Volatility Smart Beta ETFs Make Sense?)

The departures from SPLV and USMV come as the ETFs have started looking a lot different than investors have come to expect from minimum volatility strategies. For example, USMV allocates nearly 38% of its combined weight to the healthcare and technology sectors, the two best-performing groups in the S&P 500 this year. Technology is the fifth largest sector weight in SPLV at 11.7%, one of the ETF's highest weights to that sector in its more than six years of trading. SPLV allocates over one-third of its combined weight to industrial and financial services stocks, indicating that low volatility strategies are not always utilities or consumer staples ETFs in disguise as critics have previously alleged.

"From May 1, 2016, through June 30, 2017, USMV generated an annualized return of 12.61% for investors," according to Morningstar. "Meanwhile, investors' collective cash-flow-weighted return was negative 0.63%. This yawning behavior gap shows there is ample room for improvement in the manner in which investors use these funds." (See also: Smart Beta: Are Low Volatility ETFs Short Sighted?)

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