Slide in ETFs that buy 'safe' stocks shows market volatility was no freakish VIX blip

Key Points
  • Minimum volatility stock ETFs are designed to focus on 'safer' names in the market.
  • In the sudden market downturn, these ETFs have not held up much better than other stocks.
  • Over the long-term, these ETFs may work as planned, but they did flash a warning: There's been no place safe to hide.
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Investors hoping the sudden volatility would stop and the stock market would get back to its bull run are probably realizing that was wishful thinking. Many market watchers zeroed in on the role of inverse ETFs that short the VIX volatility index as a sign that this downturn was a freakish blip. But trading in ETFs designed to buy less volatile stocks, known as minimum volatility ETFs, are suggesting a trend more ominous right now: There's no place in the market that's safe to hide — at least not just yet. Stocks that fit a minimum volatility strategy are getting marked down almost as aggressively as the market as a whole.

Based on trading history, the VIX itself has signaled that volatility will not vanish. In a note published Thursday, DataTrek Research took a look at the ETFs designed for minimum volatility and found they are selling off not just alongside the market but almost as much. That leads DataTrek to the conclusion that there's no stock safe from big repricing.

DataTrek looked at trading in USMV (iShares Edge MSCI Min Vol USA) and SPLV (Powershares S&P 500 Low Volatility Portfolio). Combined, they have $24 billion in assets under management and are the two most popular minimum volatility ETFs focused on U.S. stocks.

The goal of these ETFs is to capture most (75 percent) of the upside move in U.S. equities but limit downside exposure during downdrafts (50 percent or less). They own stocks with less actual price volatility and exclude stocks with higher levels of turnover. And DataTrek noted that over much of the last five years, this approach has worked well enough:

  • S&P price return from 2013–17: 90.6 percent
  • Price return for USMV: 84.1 percent
  • Price return for SPLV: 74.7 percent

But the past few days reveal a few troubling stats. The downside capture for USMV/SPLV from the January peak for the S&P 500 (Jan 26 close) to now: 93 percent to 94 percent. And the returns:

S&P: down 6.7 percent
USMV: down 6.3 percent
SPLV: down 6.2 percent

The downside capture over the last month was more than 100 percent. And the returns:

S&P 500: down 2.2 percent
USMV: down 2.9 percent
SPLV: down 3.4 percent.

From Dec. 15 to the end of the year to the Jan.y 26 closing highs, USMV/SPLV underperformed dramatically. The S&P 500 rose by 8.3 percent; the average performance of the two funds was just 3.9 percent (or 47 percent upside capture), DataTrek noted. Investors have noticed: USMV/SPLV show negative money flows over the past week to the tune of $770 million.

One potential wrinkle is dividend yields. Dividend stocks get hit hard as interest rates go up, since higher rates make dividends less attractive for the stock risk entailed. But Colas said these ETFs don't have an outsized yield compared to the S&P 500, so the rate issue isn't necessarily hurting them.

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"We have no view on whether USMV or SPLV are worth owning here — the point of this exercise is to better understand how volatility is rippling through U.S. stocks and when it may subside," Nicholas Colas, co-founder of DataTrek Research, wrote.

It's worth noting that the Vanguard Group — which has never been one to launch a new fund based on a fad unworthy of long-term investment — has plans to launch a minimum volatility ETF among its upcoming slate of new ETFs.

"Over full market cycles, minimum volatility funds are designed to provide investors a smoother ride with market like returns and substantially less risk, which is exactly what they have consistently done," said Rob Nestor, head of iShares Smart Beta at BlackRock. "There can be days or even weeks where this up-and-down capture is not perfect, but over any substantially longer period in history, minimum volatility has never failed to deliver as it is designed."

Colas noted that these ETFs did on Wednesday what they were designed to do: Both SPLV and USMV outperformed. But on Thursday, the ETFs ended down much closer to the S&P 500 decline.

DataTrek drew three broader conclusions:

1. The narrative about the effect of VIX-linked ETFs on the market isn't enough. Investors seem to be repricing risk on an almost name-by-name basis.

2. This is limiting investors' ability to hide from market volatility.

3. The minimum volatility strategy is a useful canary in the coalmine that is the U.S. equity market.

4. Monitoring these minimum volatility funds may be a good way to know whether volatility is truly ebbing.

"While it might be tempting to look at high-volatility stocks for a sign investor confidence has returned, it feels like a tall ask to expect those names to rally convincingly just now," Colas wrote. "So keep an eye on how SPLV and USMV trade in the coming days — outperformance there will be a useful 'tell' about the health of the market as a whole."

This story has been updated to include comment from BlackRock iShares executive.