Low-vol ETFs on tear, but skeptics remain

Low-volatility exchange-traded funds have surged in popularity this year, but some financial advisers remain skeptical that the products are anything more than clever marketing.

During last month’s rush back into stocks, low-volatility ETFs took in $1.5 billion in net inflows, according to the ConvergEX Group.

That may seem like a drop in the bucket, compared with the $29 billion that went into all equity ETFs in January, but it puts them well on pace to top — in the first quarter alone — all of last year’s $4.2 billion in inflows.

It isn’t hard to see why low-volatility ETFs, which invest in the least-volatile stocks in a broad index such as the S&P 500 or Russell 1000, have taken off with investors who might still be spooked by the V word.

“It’s an easy sell to clients,” said Mike Rawson, an ETF analyst at Morningstar Inc. “It’s going to give you exposure to the markets without all the risk.”

In theory, at least, low-volatility ETFs are expected to underperform in up markets and outperform in down markets, leading to a smoother ride over the long term.

So far, the first half of that promise has proved true. Both the $3.2 billion PowerShares S&P 500 Low Volatility ETF (SPLV) and the $1.46 billion iShares MSCI USA Minimum Volatility ETF (USMV) had returns of about 10% last year, while the S&P 500 gained about 15%.

How the ETFs will perform in a down market is still anyone’s best guess because the products haven’t been tested yet.

Invesco PowerShares Capital Management LLC launched the first low-volatility ETF, the PowerShares S&P 500 Low Volatility ETF (SPLV), in late 2011, and it already has grown to more than $3 billion in assets. Other providers have taken note of its success, and there are now 11 such ETFs, four of which were launched this month.

“We have no idea how it would’ve done in 2008,” said Roger Wohlner, a financial planner at Asset Strategy Consultants.

Mr. Rawson has a different qualm with low-volatility strategies — for the moment, at least.

“It’s a difficult market environment right now for a lot of strategies that have worked really well, historically,” he said.

“We’ve seen dividends get a little stretched, and low volatility has fallen into the same camp,” he said. “It’s expensive relative to the market.”

DIVIDEND STRATEGY OVERLAP

Even though low-volatility ETFs have less than $10 billion in assets combined, they do tend to overlap quite a bit with dividend strategies such as the $13 billion Vanguard Dividend Appreciation ETF (VIG) and the $10 billion SPDR S&P 500 Dividend ETF (SDY).

That’s because big, stable companies tend to be less volatile and pay out steady dividends. For instance, Vanguard’s dividend ETF has a 24% allocation to consumer staples, and the PowerShares S&P 500 Low Volatility ETF has a 27% weighting to that sector. The S&P 500 has an 11% weighting.

The PowerShares low-vol ETF trades at about 15 times forward earnings, compared with the S&P 500’s 13 times.

That is why Andy Kapyrin, director of research for RegentAtlantic Capital LLC, speaking recently to his firm’s investment committee, recommended against using low-volatility ETFs for clients.

“My primary concern is that these strategies may have become victims of their own success,” he said.

Larry Whistler, chief investment officer of Nottingham Advisors, started adding low-volatility ETFs to his portfolios in the past six months and is watching valuations closely.

“We’re not at the point of concern yet, but it’s on our radar screen,” he said. “There’s no quicker way to kill a nice strategy than to have it become popular.”

For now, though, Mr. Whistler is holding on to low-volatility ETFs because of their ability to lower the risk in a portfolio.

Last year, the iShares MSCI USA Minimum Volatility ETF, which he uses, captured 65% of the upside in the market and just 23% of the downside.

The average large-cap mutual fund, by comparison, captured 93% of the upside and 73% of the downside, according to Morningstar.

“We spend as much time managing for risk as we do for return,” Mr. Whistler said.