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  • Home>Research & Insights>Investment Insights>Why Have Investors Bailed on Low-Volatility Funds?

    Why Have Investors Bailed on Low-Volatility Funds?

    A bout of underperformance seems to have led many to jump ship.

    Ben Johnson, 07/28/2017

    A version of this article was published in the July 2017 issue of Morningstar ETFInvestor. Download a complimentary copy of ETFInvestor here.

    In May 2016, I called attention to the fact that investors had apparently fallen head over heels for low- and minimum-volatility exchange-traded funds and that valuations for these funds had grown rather ripe:

    "For the year to date, the top-ranked ETF by net new inflows is iShares Edge MSCI Minimum Volatility USA ETF USMV. The fund has vacuumed up $4.7 billion in net new investor capital during the first four months of the year. As more money has piled into this fund and others like it, valuations have richened commensurately. At current levels, newcomers to the low-volatility party could be setting themselves up for disappointing future returns.”

    From the end of April 2016 through June 2017, USMV underperformed iShares Core S&P Total U.S. Stock Market ETF ITOT by nearly 5 percentage points. Generally, this is what investors should expect. 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.

    Source: Morningstar Analysts.

    Apparently, some investors in these funds didn't get the memo. During the eight-month period spanning from August 2016 through March 2017, USMV and its chief rival, PowerShares S&P 500 Low Volatility ETF SPLV, witnessed a combined $4.6 billion in net outflows.

    It's awfully difficult to discern why so many turned sour on these funds. My best guess is their relative underperformance was the primary driver. For example, USMV lagged ITOT by nearly 7 percentage points during this span. But again, that is (in theory) what they signed up for.

    The net result is another testament to the fact that we are our own worst enemies. From May 1, 2016, through June 30, 2017, USMV generated an annualized return of 12.61% for investors. 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.

    Ben Johnson is Morningstar’s Director of European ETF Research.