The iShares Edge MSCI Minimum Volatility USA ETF (BATS:USMV) invests in a basket of stocks that have historically presented a lower beta and lower volatility relative to the market. The concept of a low volatility fund is attractive for investors that may be risk-averse or seek to take a defensive approach to equity exposure. There is also academic evidence suggesting the minimum-volatility factor tends to outperform the market over long periods. Favorably, USMV has beaten the S&P 500 Index (SPY) since its inception in 2011. On the other hand, we highlight that USMV fell by as much as 33% from its previous high to the recent market low which was approximately equal to the drawdown in the S&P 500. The results of the fund this year highlights some important weaknesses in the strategy that investors should be aware of in terms of risk management.
There is empirical data that shows low-volatility stocks, which are those that have less price variability on average than the market, tend to deliver excess returns. In academic literature, this dynamic is referred to as the “low-volatility anomaly” because it’s counterintuitive to the idea that returns are proportionally related to risk in that higher risk should offer higher return potential.
Several ideas have been put forth to explain the anomaly. Our preferred theory is that since most active investors seek to outperform the market, they will tend to gravitate towards higher beta stocks which drive up the valuations in that segment of the market. This leaves “low-beta” stocks as underappreciated which creates a higher risk-adjusted return potential.
Indeed, data shows that since the inception of the USMV ETF in October of 2011, the fund has returned 151% compared to 145% in SPY over the period which includes the recent coronavirus sell-off. On a trailing five-year basis, the outperformance is even greater with USMV returning 45% compared to 36% in SPY on a total return basis.
Taking a look at the current composition of the fund across 213 equities, the portfolio features an otherwise diversified collection of large- and mid-caps. The underlying holdings based on the tracked “MSCI USA Minimum Volatility USD Index” includes stocks with the lowest absolute volatility while also including some factor constraints like the company’s financial leverage.
Technically, the minimum-volatility index is looking at historical returns variance through a covariance matrix and an optimization model. There is a semi-annual review in May and November where the index and fund are rebalanced “re-optimized” with each holding initially limited to a 1.5% weighting and adjusted for liquidity measures.
(Source: Seeking Alpha Premium)
With data through February 28th, 2020, Newmont Corp. (NEM) is the largest holding with a 1.8% weighting. This is consistent with the strong returns of gold mining stocks over the past year relative to the market which has made NEM gain relative importance within the portfolio while other stocks have declined. NextEra Energy Inc. (NEE) and Coca-Cola Co. (KO) each with a 1.6% weighting are the next largest holdings. The important consideration here is that the composition of the fund is based on historical returns data. As we highlight below, some of these stocks faced extreme levels of volatility which limited the value of the strategy during a stress scenario.
The fund manager iShares’ marketing material claims USMV as offering exposure to U.S. stocks with “potentially less risk”. Separately, iShares shows that USMV has historically declined less than the market during downturns. The reality is that in 2020 given the historic coronavirus pandemic selloff, USMV was unable to generate downside protection.
Considering the recent market low in the S&P 500 on March 23rd, 2020, data shows that USMV suffered a drawdown of 33.1% compared to 33.72% for SPY. In this regard, iShares is technically correct that the fund generally declines less than the overall market, but the 66 basis point outperformance to the downside hardly provides solace to investors that may have been surprised by the sharp move lower.
The explanation here is simply that the sell-off represented a systematic event that was widespread across all market sectors. Scenarios like the shutdown of retail stores across major cities with consumers quarantined were unimaginable just a few months ago. The implications of the disruption to economic activity raise the risk of a deeper structural slowdown and corresponding impact to consumer spending for an extended period representing significant uncertainty.
One of the factors that have been detrimental to the performance of the minimum-volatility ETF is the unique challenges facing several companies that are otherwise unprecedented. For example, with social distancing measures being practiced around the world, Coca-Cola beverages are no longer being sold at sporting events, concerts, restaurants, and other large public gatherings that are typically high consumption and revenue channels. This is simply one example of a disruption that may not have ever been priced into the stock’s risk profile.
Even utilities within the fund like NextEra Energy are seeing a collapse in the demand for electricity with a decline in industrial activity and commercial users. The point here is that USMV’s underlying holdings have been challenged by risks that may not have even been previously considered.
Analysis and Forward-Looking Commentary
Following the market low across major broad market indexes on March 23rd, we’ve observed an impressive rally with the S&P 500 rebounding by as much as 20%. There is a growing sense of optimism that the pandemic can be at least managed in terms of the public health crisis and near-term economic impacts. Investors are hopeful that the aggressive monetary and fiscal policy actions by the Federal Reserve and the U.S. government can mitigate the otherwise serious financial consequences.
That being said, we see several risks going forward and maintain a cautious view on equities in general. The main concern here is that the pandemic continues to accelerate cities across the U.S. and different regions of the world. The longer the outbreak represents a serious health risk, we expect disruptions to continue to represent poor sentiment towards the recovery and risk sentiment. Outside the United States, conditions are deteriorating globally which represents pressure on the operating environment of companies with business internationally, including those constituents of the USMV ETF. We expect conditions to remain volatile for the foreseeable future.
The iShares Edge MSCI Minimum Volatility USA ETF is based on an empirically-backed investing strategy that has shown to outperform the market over long periods. While recognizing the positive return of the fund against the S&P 500 over the past decade, the recent period of extreme volatility highlights some limitations of the construction methodology.
The weak performance of USMV to the downside with a max drawdown of 33% is disappointing to investors that may have expected a lower risk vehicle. By focusing too much on historical returns and statistical data, USMV was unprepared to deal with a shift in market conditions that broke many long-standing correlation themes across equity factors. While the market and USMV may rebound from here and resume its trends higher, we fail to see the value compared to a broad market index. We recommend a better approach towards diversification across market segments and asset classes that includes an allocation to fixed-income funds to better manage portfolio risk.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.