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Investors flooding billions into this ETF may have unrealistic expectations

A close look at the hot low-volatility trend

If outperforming the market while being exposed to a lower level of risk sounds attractive to you, you're not alone.

This year, some $5 billion has flowed into the iShares Edge MSCI Minimum Volatility USA ETF (USMV), a product that is designed to deliver lower volatility than the market.

Part of the reason for the surge of funds into the now-$13 billion ETF is no doubt its stellar recent performance; over the past year, it has risen about 8 percent even as the S&P 500 is down nearly 2 percent.

There's just one problem: Risk is the key ingredient in that delicious dish known as market returns — and just as one cannot make more guacamole with less avocado, one generally cannot make more money by risking less of it.

This point can be made by cracking out the chalkboard and spelling out some financial formulas, but the "no free lunch" framework works just as well.

Imagine that there does exist a product that serves up the same returns as the S&P 500 with half as much risk. In the parallel universe that includes this potential investment, no investor who is able to borrow money would buy a product that tracks the S&P, since one could risk just as much and perform (almost) doubly as well by instead borrowing to buy the less-risky product.

This would continue to be done until the half-risk product is bid up so high that it only offers half the returns of the S&P 500. (Or, technically, until it offers half the returns plus the cost of borrowing, but one gets the point.) The upshot is that the opportunity granted by the underpricing of this product is swiftly arbitraged away in any vaguely efficient marketplace.

For this reason, any conclusion that a product can consistently outperform the market when its returns are adjusted for risk must be treated with great skepticism. The risk is that investors take recent performance as evidence that the market gods have delivered them a miracle.

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The marketers of the iShares product appear to have let the performance get to them. While BlackRock's informative website about the USMV carefully explains that the ETF "may help reduce losses during declining markets while still experiencing gains during rising markets," an April brochure says that "iShares Edge Minimum Volatility ETFs have delivered market-like returns with less risk," a true claim that tells us little about what the future will bring.

"Investors' aim with low volatility strategies shouldn't be to outperform the market, rather to reduce risk and to measure that performance over a full market cycle," BlackRock's head of iShares smart beta strategy, Robert Nestor, said in an email to CNBC on Monday.

In addition, it is important to note that low volatility may describe the product, but not some of the stocks contained within it. The ETF's single largest holding is gold miner Newmont Mining, which also happens to be the single best-performing stock in the this year. That name is a highly volatile one which appears to have found its way into the MSCI index the USMV tracks by dint of its very low correlation with the market as a whole.

To be sure, it is eminently possible to put together a set of stocks that collectively delivers lower volatility than the S&P 500 (or any other broad index), and this is what the designers of the index tracked by this ETF have done. But the salient question is whether such a strategy will outperform a more typical approach to taking the desired amount of risk in one's portfolio.

"What we do is we develop portfolios for our clients based on their risk tolerance and return expectations," Bryn Mawr Trust's chief investment officer, Ernie Cecilia, said Thursday on CNBC's "Trading Nation," describing the vanilla approach to portfolio management.

"To look to one particular ETF or one security to accomplish all of your goals ... is just not the right approach."