ETF Strategist

The case for (and against) wimpy ETFs

In the past three years, the category of low-volatility ETFs has mushroomed from two—PowerShares' and iShares both introduced low-volatility S&P 500 funds in 2011—to 14. The funds promise to track, with lower volatility, everything from emerging markets to the global stock market. Vanguard Group recently got in the game, with the introduction of a low-volatility index fund.

Investors have been drawn in by the concept—and maybe the label. Even six years after the financial crisis, the idea of low volatility has a particular emotional appeal. PowerShares' S&P 500 Low Volatility ETF (SPLV), the largest low-volatlity ETF, now has more than $4 billion in assets, and iShares' MSCI USA Minimum Volatility ETF (USMV) has $2.4 billion. So far, the funds have been performing as you'd expect: with lower volatility (as defined by standard deviation). SPLV has also outperformed the S&P 500 so far in 2014 by a healthy margin—a big concentration in utilities stocks, which led all sectors in the market earlier this year, is a big reason for that combination of lower volatility without sacrificing performance.

But the low-volatility funds should be approached with caution. In short, whether they work or not is an open question.

DNY59 | E+ | Getty Images

"Slapping a label on something isn't really delivering on the promise of low volatility," said Todd Shriber, Web editor at Irvine, California-based ETF Trends.

A recent Wall Street Journal article went beyond caution, saying that given the recent performance run, it's time to "flee" these low-volatility funds.

Recent performance, though, doesn't tell the full story that the long-term investor needs to know in weighing the low-volatility approach as a core holding, or complement to a core holding, rather than well-timed ETF trade. On the plus side, these ETFs have fairly low expense ratios, but they take vastly different approaches and have no track record during a serious downturn in the market—which is when you'd be most likely to want to minimize volatility.

The lack of a track record is a complaint that has also dogged so-called ETF strategist funds, professionally managed ETF funds of funds that seek to reduce volatility and have delivered in recent years, but have yet to be proved over longer market cycles.

Dan Draper, managing director of PowerShares, is used to the debate. He said recent history and SPLV's return history confirms academic findings that there is a low-volatility anomaly, and it allows the approach to not only reduce risk but also generate healthy returns. Since inception of SPLV in May 2011 through the end of March, SPLV has slightly outperformed the S&P 500 Index. Draper said this is coming with less volatility and includes the bull market of 2013.

Read MoreThe biggest wealth destroyer in the market, an ETF?

All of the low-volatility ETFs are equity funds, so far, and equities are an inherently volatile asset class, points out advisor Ed Gjertsen II, vice president of Glen View, Illinois-based Mack Investment Securities. The classic way to lower risk is not to stay 100 percent in equities but to diversify among asset classes: to add bonds or real estate, say, to leaven your exposure to stocks. So if you're interested in a low-volatility ETF in order to minimize your equity volatility, that's all well and good. If, on the other hand, you're under the assumption that you're taking a serious approach to lowering the risk of your overall investments by buying a low-volatility ETF ... well, you've probably been led astray.

"Don't be fooled by the minimum-volatility tag," said Gjertsen. "Look at what's under the hood."

"Bonds and real estate are risk assets like stocks," Draper said. He said SPLV outperformed a traditional stock/bond blend during the three worst drawdowns of the S&P 500 Index since May 2011. "Going deeper, bonds have duration risk. At current interest rate levels, an ensuing rise in interest rates may have a material negative impact on bond prices and generate volatility for a portfolio due to the duration effect," Draper said.

PowerShares also looked at a main real estate index, the FTSE NAREIT Composite Index, on a monthly return basis since 1990 and found it produced higher volatility than the S&P 500—18.5 percent to 14.7 percent.

Although SPLV has only traded since May 2011, it has existed through 3 of 4 market selloffs related to the eurozone financial crisis—spring/summer 2011, spring/summer 2012 and fall 2012. During these periods, the S&P 500 Low Volatility Total Return Index posted a smaller decline than the S&P 500 by an average of 6.57 percent, and the decline was an average of just 35.5 percent of the drop in the S&P 500 Total Return Index, Draper said.

The widows-and-orphans approach to investing
Even the two largest ETFs have widely different approaches—and critics say there is no good evidence for how well these funds will perform over time.

You could call SPLV a shortcut to the kind of portfolio your grandmother might have been comfortable with: About one-fourth of it is in utility stocks, according to Shriber.

SPLV's strategy is pretty simple. It takes the S&P 500 and overweights the least volatile sectors. The benchmark it tracks, the S&P 500 Low Volatility Index, consists of the 100 stocks within the broader S&P 500 Index with the lowest volatility over the past 12 months, making it typically concentrated in the traditional defensive sectors: utilities, consumer staples, and industrials. But it's important to remember that the least volatile sectors are not always the least volatile. In 2002, Gjertsen pointed out, so-called "widows and orphans" stocks, like utilities, took a beating.

And as S&P Capital IQ noted in a report on the rise of low-volatility ETFs last year, even if they make sense for the long term, outflows can occur for these strategies, based on short-term changes in market sentiment. Last May, when the market became obsessed with the idea that the Federal Reserve would soon slow its bond-buying program, low-volatility funds experienced outflows.

I think lots of stuff in investments goes back to the future, where lots of these strategic dividend payers and the Nifty Fifty that go back decades become the strategy du jour again. I don't know if in the long-only space there is ever anything new, just to some extent some ideas recycled.
Brian Birnbaum
partner, Mercer Investment Consulting

In markets where the overweighted sectors are performing badly, SPLV could run into trouble—it might not only be more volatile but its returns could suffer. "Those reduced diversification benefits could be a potential problem," said Alex Bryan, fund analyst at Chicago-based Morningstar in passive fund research.

In 2013, a year when the S&P 500 returns were more than 32.4 percent, SPLV returned about 23.3 percent. In the year ending March 31, SPLV returned 12.5 percent, compared with the S&P's 21.9 percent.

Read MoreThe ground is shifting in the ETF industry, Bogle's way

Draper said the idea that low-volatility funds target the same defensive sectors and never deviate is wrong. In fact, PowerShares takes up this issue in its research paper, making its case for SPLV, writing that while SPLV can be overweight utilities and consumer staples, the sector allocations are not static. Low-volatility stocks across sectors do tend to remain low-volatility stocks, but PowerShares looked at how its basket of low-volatility stocks changed during three recent crashes—the dot-com bubble, the Enron fallout for the energy and utilities sector, and the financial crash—to show that the unconstrained low-volatility approach can make significant shifts into and out of specific sectors during periods of underperformance.

iShares' USMV is constructed differently than SPLV in that the underlying MSCI benchmark USMV tracks takes on less sector-weighting risk and is typically more broadly diversified across all sectors. Across its 134 stocks, health care and consumer staples are typically large weightings, but financials and information technology are also well represented. In 2013 all but the materials sector made up more than 4 percent of USMV, S&P Capital IQ noted in a report. The iShares ETF returned 25 percent in 2013, and in the year ending March 31, it returned 12.6 percent. The downside is that the MSCI index is not unconstrained like SPLV, meaning even during periods of sector upheaval, it has to maintain its index mandate weighting to each sector.

"You want to make sure these products are being advertised correctly. You stand more chance of finding truth in advertising with the larger names," Bryan said. Because of the complexity of the strategy, "I would tend to stick with the larger names."

Investing abroad with the white-knuckled
iShares announced on June 5 that it is adding three new low-volatility ETFs—it brands them as "minimum volatility"—targeting Europe, Japan and Asia ex-Japan.

Even more of the low-volatility funds are likely to crop up in emerging markets, Shriber said. iShares has the MSCI Emerging Markets Minimum Volatility ETF (EEMV), while PowerShares offers the S&P Emerging Markets Low Volatlity ETF (EMLV).

An S&P research paper found that the "low-volatility effect"—less risk without sacrificing return, even outperformance of market-weighted indexes—is, in effect, on a global basis, including in the emerging markets.

Here, it's important to recognize that the strategy of a low-volatility fund is likely to be under or overweighting particular countries. So South Korea, which is one of the most developed of the emerging markets, might be overweighted. Yet, if overweighting South Korea means a big underweight in India, you may well be sacrificing more returns than you want, Shriber said.

Of course, the whole idea of a low-volatility emerging markets ETF begs the question: What are you really looking for? If you want a handy way to invest in emerging markets with overweights or underweights in particular countries you like or don't like, by all means look under the hoods and buy. But if you're buying the ETF because you're worried about the risks of emerging markets, that may be a clue that you're not really comfortable with this most volatile of equity sectors.

Institutions are doing it
In fact, on the institutional side of investing, low-volatility funds have caught on due to more investors going abroad and in greater portfolio concentration, but without trying to avoid risk in inherently risky markets. Mercer Investment Consulting partner Brian Birnbaum said many institutional investors use low-volatility strategies to offset emerging markets rather than a way to invest in emerging markets.

Mercer believes that in an ongoing global economic rebalancing away from developed markets toward emerging markets, there will be a structural overweight to higher levels of volatility. Global equities market cap is now 55 percent non-U.S., and within the non-U.S. market cap, it is as much as 25 to 30 percent emerging markets.

Read MoreCan anything save active management?

Over time, that could rise to 40 percent emerging markets for institutions with a high-risk tolerance, Birnbaum said. The low-volatility equity approach should continue to be a trend, since more return will be coming from the historically more volatile markets, Birnbaum said. The developed markets become, in a sense, your classic widow-and-orphan dividend plays. In some respects it is like the return of the Nifty Fifty, which was en vogue decades ago, Birnbaum said. But it is also a recognition of the rise of quantitative investing—these low-volatility approaches lend themselves to the quantitative equities structure.

For individual investors, there is a very established way to invest in the same way as the low volatility ETFs: buying the individual stock names long associated with safety. Within the top 10 holdings of these ETFs are companies such as Johnson & Johnson and PepsiCo.

"I think lots of stuff in investments goes back to the future, where lots of these strategic dividend payers and the Nifty Fifty that go back decades become the strategy du jour again," Birnbaum said. "I don't know if in the long-only space there is ever anything new, just to some extent some ideas recycled."

Why are investors pouring into bond ETFs?
Why are investors pouring into bond ETFs?