Last week I wrote a post on ETFs have been a catalyst for the widespread adoption of broadly diversified, low cost portfolios. However that does not mean that exchange traded funds are an unalloyed good. In my book I spend as much time talking about the benefits of ETFs than I do the potential downsides.
One potential downside is that once an ETF on a novel strategy come to market investor expectations can get affected and not in a good way. Take for instance the area of low volatility ETFs. I have been writing about the low volatility anomaly for some time now. A dozen (or so) ETFs have been released that track in various ways low volatility strategies on the US, developed and emerging markets. These funds were released in large part because of the academic research showing that, paradoxically, low volatility (or low beta) equities tend to outperform the market on a risk-adjusted basis.
This evidence of course flies in the face of the CAPM. Eric Falkenstein author of The Missing Risk Premium recently co-authored a paper looking at various explanations for this anomaly. Indeed one could argue that the low volatility anomaly is better described as the high volatility anomaly because of the historically poor performance of high volatility equities.
The research on low vol is pretty convincing. What this research also shows is that the low volatility effect is seen over full market cycles. Indeed one of the biggest arguments against trying to implement a low vol strategy is that it can dramatically underperform the broad market for extended periods of time.
In the meantime the financial media has gone into nuts over the recent underperformance of low vol strategies after an extended period of outperformance. This recent outperformance was the catalyst for sizable inflows into the two largest low vol ETFs: the PowerShares S&P 500 Low Volatility ETF ($SPLV) and the iShares MSCI USA Minimum Volatility Index ETF ($USMV). This performance also attracted a fair amount of ‘hot money’ as well and this hot money has begun to jump ship. This reversal has prompted a wave of breathless headlines like:
Given the coverage you would think that the outperformance of low vol was a one-time thing has been played out. First a reading of history would show that low vol strategies can underperform, like any other strategy, for periods of time. Second you would have to think that a few billion of inflows into some ETFs would somehow offset the behavioral and structural effects underlying the low vol anomaly. There is a big mismatch between the time frame of the coverage and the underlying dynamics of the low vol effect.
The bottom line is that we would not be seeing this coverage were it not for the existence of these low vol ETFs. The existence of these ETFs has been a boon for investors because it provides them with easy, relatively low cost access to these still novel strategies. However it also allows for investors to jump ship at the first sign of trouble. Investors who think they can time the low vol effect, or any other effect, are acting as de facto market timers, not long-term investors seeking to exploit a market anomaly.
The media isn’t helping in this regard. A little bit of perspective would do investors a greater service than focusing on weekly fund inflows and outflows and short-term performance. As I have written before: alpha is promised to no one, not even the low volatility crowd despite the impressive track record. Once you stray beyond broadly diversified index funds the risk (and anxiety) of underperformance is always there. Any one looking to take advantage of this effect or any other has to have a time horizon longer than that of a financial media.
Items mentioned above:
Financial innovation for once works for the investor. (Abnormal Returns)
Abnormal Returns: Winning Strategies from the Frontlines of the Investment Blogosphere by Tadas Viskanta. (Amazon)
Low volatility, high interest. (Abnormal Returns)
The low volatility effect in the spotlight. (Abnormal Returns)
Low volatility ETF list. (ETFdb)
The Missing Risk Premium by Eric Falkenstein. (Amazon)
Explanation for the Volatility Effect: An Overview Based on the CAPM Assumptions by Biltz, Falkenstein and Vliet. (SSRN)
The low volatility anomaly and the CAPM. (Portfolio Probe)
Why low volatility is losing its alpha. (IndexUniverse)
Bandwagoners jump off the ‘low volatility’ ETF. (Focus on Funds)
Is the “low-beta bubble” deflating? (Barron’s)
When low volatility bites back. (IndexUniverse)
A ‘low risk’ trade is getting less safe. (WSJ)
No, it’s not a minimum variance bubble. (iShares Blog)
Alpha is promised to no one. (Abnormal Returns)
Peace of mind and active management do not go together. (Abnormal Returns)