What future returns can be expected?
The article was published in the May 2016 issue of Morningstar ETFInvestor. Download a complimentary copy of Morningstar ETFInvestor by visiting the website.
For the year to date, the top-ranked equity exchange-traded fund by net new inflows is iShares Edge MSCI Minimum Volatility USA USMV. The fund vacuumed up $6.7 billion in net new investor capital during the first seven months of the year. As more money has piled in to this fund and others like it, valuations have richened commensurately. At current levels, newcomers to the low-volatility party could be setting themselves up for disappointing future returns.
In Exhibit 1, I’ve plotted trailing-12-month flows into USMV on the left-hand vertical axis. As you can see, flows have been generally positive since USMV’s late-2011 inception. More recently, they’ve spiked higher. On the right vertical axis, I’ve plotted the ratio of USMV’s trailing-12-month P/E ratio to iShares Core S&P Total US Stock Market’s ITOT trailing-12-month P/E. This is a simple measure of relative value. When the figure is greater than 1, USMV is relatively richly valued versus ITOT. When it is less than 1, USMV is relatively cheap.
Clearly, USMV has been getting relatively rich versus ITOT since the second half of 2013. The ratio of the two funds’ P/E ratios was 0.97 as of the end of August 2013--the last time it was below 1. As of the end of July, the ratio stood at 1.24. USMV’s valuation has also gotten richer in absolute terms. At the end of August 2013, the fund’s trailing-12-month P/E was 17.05. As of the end of July, it had expanded to 23.97.