It's easy to feel comfortable with risk in the midst of a nine-year bull market, only to regret it when the good times end. If you've bitten off more risk than you can chew, a more conservative asset allocation or defensive equity fund can help. Defensive equity funds still carry equity risk, but they should hold up better than the market during downturns. Among these, iShares Edge MSCI Minimum Volatility USA ETF (USMV) is one of the best.
This is a well-crafted strategy that takes a holistic approach to reduce volatility and preserve diversification. And it only charges 0.15%. It should offer a smoother ride and a better risk/reward profile than most of its peers in the large-blend Morningstar Category. But it has not yet been tested in a major market downturn, so it earns a Morningstar Analyst Rating of Silver.
The fund attempts to construct the least volatile portfolio possible with stocks from the MSCI USA Index, which includes large- and mid-cap names, under a set of constraints. These include limiting turnover, exposure to individual names, and sector tilts relative to the MSCI USA Index, which improves diversification. This strategy doesn't just target the least-volatile stocks. It also considers how stocks interact with each other, which allows it to better reduce volatility at the portfolio level.
The portfolio includes more than 200 holdings, such as Procter & Gamble (PG), Johnson & Johnson (JNJ), and PepsiCo (PEP). These firms tend to enjoy more-stable cash flows and less-volatile returns than the typical constituent in the MSCI USA Index. But some volatile names can make the cut if they have low correlations with the other stocks in the portfolio.
So far, the fund's approach has worked well. From November 2011 through July 2018, the fund exhibited 17% less volatility and about a third less market sensitivity than its parent index. And while it lagged the benchmark by 103 basis points annually during that time, it still generated better risk-adjusted performance than most of its peers.
Performance will not always be strong. The fund will likely lag during bull markets and probably won't generate market-beating returns over the long-run. But it should hold up better than most of its peers during downturns and offer better risk-adjusted returns than the MSCI USA Index over a full market cycle. Its holdings may be priced to offer attractive returns relative to their risk because their tendency to lag in bull markets can make them unattractive to benchmark-sensitive investors.
Low-volatility stocks have historically offered a more favorable risk/reward trade-off than the market and will likely continue to do so because of behaviorally induced mispricing and constraints that asset managers face. Riskier stocks tend to have greater upside potential than defensive stocks, which makes them more appealing to investors who care about earning high returns, like mutual fund managers who are trying to beat a benchmark. These collective bets on risky stocks can cause them to become overvalued and offer less attractive compensation for their risk than their more defensive counterparts.
Past volatility isn't a strong predictor of returns for most large-cap stocks. However, it is a good predictor of future volatility and downside performance, at least in the short term. This risk reduction is the principal source of low-volatility stocks' attractive risk-adjusted performance.
This fund doesn't directly target stocks with low volatility, though it still heavily favors them. It considers expected individual stock volatility and correlations across stocks, under a set of constraints, like limiting sector tilts. This holistic approach causes the fund to own some more-volatile stocks than it would if it simply targeted the least-volatile stocks in the market. However, it should lead to a better-diversified portfolio that can translate into lower risk at the portfolio level. No measure of risk is perfect. Low volatility can mask risks that haven't yet been realized. Investing in stocks with low correlations with one another can help reduce the portfolio's exposure to sources of risk that past volatility may not capture.
Interest-rate risk is one of those risks that past volatility may not capture. Morningstar research suggests that low-volatility stocks tend to be more sensitive to interest-rate fluctuations than the market. Interest rates don't change in a vacuum. They tend to rise as the economy strengthens and fall as it weakens. Low-volatility stocks are less cyclical than most, so they have less cash flow growth to offset the negative impact of rising rates. That said, it isn't prudent to time exposure to defensive stocks. Despite this risk, low-volatility stocks should still offer attractive risk-adjusted performance over the long term. It is also worth noting that this fund is a bit less sensitive to interest-rate risk than its peers that directly target low-volatility stocks.
The fund tends to have a smaller market-cap orientation than the MSCI USA Index. Its performance relative to that benchmark has historically been positively correlated with the MSCI USA Value Index's, even though it explicitly limits its tilt toward value or growth stocks. This constraint helps mitigate unintended style bets, though it doesn't eliminate them entirely.
Not surprisingly, the fund has greater exposure to defensive sectors, such as utilities, healthcare, and consumer defensive, than the MSCI USA Index. It also has greater exposure to the real estate sector and less exposure to more-volatile sectors like energy, technology, and financial services. The fund's sector constraints may prevent it from loading up on the least-volatile sectors, but they also better diversify risk.
USMV employs full replication to track the MSCI USA Minimum Volatility Index, which attempts to create the least volatile portfolio with stocks from the MSCI USA Index. The fund earns a Positive Process Pillar rating because it uses a holistic approach to reduce volatility, applies reasonable constraints to preserve diversification, and emphasizes stocks that have historically offered superior risk-adjusted performance.
The index draws on the Barra Equity Model for estimates of each stock's volatility, exposure to risk factors, and the covariances between them. Notably, the model uses each stock's factor exposures, rather than its actual returns, to estimate its volatility and covariances. However, this choice probably doesn't have a big impact on the composition of the portfolio. The risk model places greater emphasis on more-recent data, which is likely more predictive of future risk. MSCI feeds this data into an optimizer that builds the portfolio expected to have the lowest volatility, subject to several constraints designed to improve diversification. These constraints keep stock weightings between 0.05% and 1.50% of the portfolio, sector weightings within 5% of the MSCI USA Index, and one-way turnover limited to 10%. The algorithm also applies constraints to limit tilts to other factors, such as value. The index is reconstituted semiannually in May and November.
Invesco S&P 500 Low Volatility ETF (SPLV) (0.25% expense ratio) offers greater style purity than USMV but tends to make more-concentrated bets. Each quarter, SPLV ranks the stocks in the S&P 500 by their volatility over the past year. It targets the least-volatile 100 stocks and weights them by the inverse of their volatility, so that the least volatile stock receives the largest weighting. There are no constraints on sector weightings or turnover, which can be high. For these reasons, it earns a Bronze rating, one peg lower than USMV's.
SPDR SSGA US Large Cap Low Volatility Index ETF (LGLV) (0.12% expense ratio) takes a sector-relative approach to stock selection. It targets stocks with the lowest volatility in each sector over the past five years and weights them by the inverse of their volatility. This longer look-back period, coupled with the fund's infrequent annual rebalancing, will make it slower to adjust than SPLV as stocks' volatility relative to their peers changes.
Silver-rated Vanguard Global Minimum Volatility (VMVFX) (0.25% expense ratio) attempts to construct the least volatile global-stock portfolio possible, using a constrained optimization approach similar to USMV's. It invests in both U.S. and non-U.S. stocks, yielding better diversification opportunities that can reduce portfolio volatility. While this is a rules-based strategy, it does not track an index, giving the managers flexibility to better manage transaction costs. They use forward contracts to hedge the fund's currency exposure.
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Alex Bryan, CFA has a position in the following securities mentioned above: USMV. Find out about Morningstar's editorial policies.