Can low-volatility ETFs help reduce client risk?            

                I read an article in Financial Planning Magazine titled Can low-volatility ETFs help reduce client risk? To read the article, click on the following link:

                I like to read anything in the industry that discusses reducing risk so I read over the article and had a suspicion as to what the flaw was. When I confirmed the flaw, I thought it would make for interesting reading in this week’s newsletter.

Bullet points from the article:

1) EFTs are all the rage and have been for a few years due to low fees and good market linked returns.

2) EFTs are risky because most track the market (so when there is a crash, most EFTs will go with it).

3) Low volatility EFTs are different in that they use “defensive, dividend paying stocks to help mitigate market ups and downs.”

4) Because the market has been on a tear for years, more investors are gravitating money to these “low volatility” EFTs to hedge their risk.

The above all sounds like it makes sense, but does it?

The article pointed out that there are two main low volatility EFTs.

-iShares Edge MSCI Min Vol USE ETF (USMV with a .15% expense ratio)

-PowerShares S&P 500 Low Volatility Portfolio (SPLV with a .25% expense ratio)

5-Year Returns

Both EFTs have generated very similar returns than the S&P 500 with lower Beta and lower Standard Deviation. So, based on this information it would makes sense to call low volatility EFT a good way for clients to reduce risk and still generate good returns, right?

What’s the problem?

These low volatility EFTs are barely more than five years old. They have never been through a market crash. If that’s the case, how do we know what they will do in a market crash? Well, we can stress test them.

Stress testing

I put these EFTs in the OnPointe Risk Analyzer program and stress tested them against previous market crash situations. For the test, I put 50% of the money in each of the low risk EFTs.

The results were very interesting. You’ll notice in the chart below that the low volatility EFTs would have a drawdown of 35.04% if a crash like the 2007-2009 financial crisis happened again (10-15-07 – 03-02-09) and a drawdown of 25.81% from 01-01-08 – 12-31-08.

What you should also find interesting is the center column below. It’s the stress test of one of the low risk groups of tactical money managers offered by the RIA I recommend advisors use (*

The left column of numbers below is the S&P 500.

If the question is will low volatility EFTs hedge risk better than the S&P 500 while still generating an acceptable rate of return over time, the answer is yes.

If the question is whether I’d be telling clients that low volatility ETFs are a good way to avoid market risk, the answer is no.

As I’ve stated, I’m a big proponent of tactically managed strategies as my preferred way to limit drawdown risk while still generating an acceptable rate of return over time. I have no desire to see clients lose 30%+ when the next stock market crash comes.

* Past performance is no guarantee of future results. Investments are subject to risk, including market and interest rate fluctuations.   Investors can and do lose money.

Roccy DeFrancesco, JD