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Low-volatility ETFs may not be what they used to be

(MoneyWatch) No one wants to believe that the best years have come and gone. But in some instances, you have to face the facts, and low-volatility ETFs are one of those instances. In the past, their ability to produce market-like returns was as confounding as it was impressive. The operative phrase, though, being "in the past." Since then, they've had trouble recreating the magic.

Based on the academic research that has found that low-volatility strategies have provided market-like returns with less than market risk, they've become the darling of investors. They've become so popular that the August edition of's ETF Report reported that there were nearly $6 billion in net new cash flows into low volatility funds so far this year. That's roughly half of the total dollars these funds hold.

It's important to understand that such flows can change the very nature of the investments. And given the historical evidence that individual investors are virtually always late to the party (buying after periods of great performance), I thought it worthwhile to take a look at the strategies. As I noted before, a part of the explanation for the strong performance of low-volatility strategies is that they had exposure to the value premium. Another was their exposure to term (interest rate risk). Both of these factors have produced large positive returns over the past several decades.

We'll take a look at the valuation metrics of the two largest low-volatility ETFs, PowerShares S&P 500 Low Volatility (SPLV) and iShares MSCI USA Minimum Volatility (USMV). We'll then compare them to metrics of the iShares Russell 1000 (IWB), which is a market oriented fund, and the iShares Russell 1000 Value (IWD). The table below is based on Morningstar data as of August 7, 2013.

What's clear from the data is that the demand for these strategies has altered their nature. The valuation metrics of the SPLV and USMV certainly don't look like how a value-oriented fund would look. Their prices to earnings, book market, sales, and cash flow are all quite a bit higher than those of IWD -- not even close. In fact, they're metrics indicate that they're both even more "growthy" than the market-like IWD. The evidence is that over the long term the annual value premium has been 4.7 percent.

We'll now take a look at some performance data for 2013. Returns are from Morningstar through August 7, 2013.

While the underperformance of low-volatility strategies in up markets shouldn't be a surprise (the trade off is supposed to be less downside risk in bear markets), when considering the data keep in mind that the evidence demonstrates that the vast majority of returns comes from a portfolio's exposure to the factors of size and value, and that these are all large-cap funds. IWD, the most value-oriented of the funds, had the highest return, the market-like IWB had the next highest return, and the two low-volatility and more "growthy" funds had the lowest returns. Also it's important to note that this period saw term risk show up as the 10-year Treasury rate increased from about 1.9 percent at the start of the year to its current yield of about 2.6 percent.

The fact that low-volatility funds had provided market-like returns in the past without any greater volatility is an anomaly that cannot be explained by the efficient markets hypothesis. As is the case with many anomalies, their discovery often leads to their disappearance. It certainly looks like the cash flows into these strategies changed their very nature. Buyer beware.

 Tomorrow we'll discuss another instance where a heyday has come and gone: high dividend strategies.

Image courtesy of Flickr user 401(K) 2013.

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