Despite Its Valuation, This Defensive Equity ETF Is Compelling

Barron's recently published an article arguing that iShares Edge MSCI Minimum Volatility USA ETF USMV is "among the riskiest investments in the market right now." (1) That argument centers around valuations, but the headline numbers don't tell the full story.

By most measures, defensive stocks, like those that USMV favors, are trading at high valuations relative to their historical range. Based on Morningstar's fair value estimates for the stocks that make up USMV's current portfolio, the fund was trading at 1.10 times fair value at the end of August 2019. However, that does not suggest that there's an impending correction or that this fund is a particularly risky investment.

While valuations are an important determinant of long-run returns, they're not very useful for timing investments, as I've previously written. Portfolios aren't static, so comparing their valuations over time doesn't provide a clean picture of how the valuations of the stocks in the portfolio have changed. For example, technology stocks tend to command higher valuations than energy stocks. USMV's allocation to technology stocks was higher at the end of August 2019 than it was at the end of August 2014, while its allocation to energy stocks was smaller. These types of changes to the composition of the portfolio can explain part of the differences in valuations over time, diluting the link between current valuations and the portfolio's future returns.

That doesn't mean it's prudent to ignore valuations. Heeding them can lead to more-realistic performance expectations than extrapolating past performance. That said, high valuations aren't necessarily a cause for alarm. Lower-risk investments should command higher valuations and offer lower returns than their riskier counterparts. Historically, low-volatility stocks have done even better than that, offering comparable and at times better returns than the market, with lower volatility and downside risk. They're unlikely to offer such a sweetheart deal in the future, given their current valuations, but well-constructed defensive equity strategies like USMV should continue to offer better downside protection and a better risk/reward trade-off than the market over the long term.

Strategy Overview USMV, which has a Morningstar Analyst Rating of Silver, attempts to construct the least-volatile portfolio possible with stocks from the MSCI USA Index under a set of constraints to improve diversification. This strategy doesn't just target the least-volatile stocks. It also considers how stocks interact with each other, which allows it to better reduce volatility at the portfolio level by mitigating exposure to concentrated sources of risk.

The portfolio includes more than 200 holdings, such as Procter & Gamble PG, Johnson & Johnson JNJ, and PepsiCo PEP. These firms tend to enjoy more-stable cash flows and less-volatile returns than the typical constituent in the MSCI USA Index. But more-volatile names can make the cut if they have low correlations with the other stocks in the portfolio.

Reducing risk goes a long way toward improving risk-adjusted performance. Historically, there hasn't been a strong relationship between volatility and returns. This may be partially because of mispricing among less volatile stocks. Even if that isn't a factor going forward, this portfolio achieves part of its risk reduction through improved diversification, which shouldn't hurt returns.

So far, the fund's approach has worked well. From its inception in October 2011 through August 2019, the fund beat its parent index by 90 basis points annually with 22% lower volatility. More importantly, it tended to hold up much better during market downturns. Performance will not always be strong. The fund will likely lag during bull markets and probably won't generate market-beating returns over the long run. But it should continue to offer better risk-adjusted performance over a full market cycle.

Fundamental View This strategy's holistic approach to volatility reduction is effective. Individual stock volatility is a good starting point, as stocks with low past volatility have tended to continue to exhibit low risk. But past volatility isn't a comprehensive measure of risk, and screening on that metric alone can introduce concentrated sources of risk that may not always be apparent. These may include nontargeted factor tilts, sector concentration, and high interest-rate sensitivity.

This portfolio reduces exposure to these potential hidden sources of risk by targeting stocks with low correlations with one another and limiting its sector tilts relative to the market. This causes the fund to own some more-volatile stocks than it would if it simply targeted the least-volatile stocks in the market. However, it should yield a better-diversified portfolio with lower risk.

That said, this portfolio still favors low-volatility stocks and exhibits some of the biases that come with them. These stocks have historically offered a more favorable risk/reward trade-off than the market and will likely continue to do so. Riskier stocks tend to have greater upside potential than defensive stocks, which can make them more appealing to investors focused on maximizing returns, like active managers trying to beat a benchmark. These collective bets on risky stocks can cause them to become overvalued and offer less attractive compensation for their risk than their more defensive counterparts.

Past volatility isn't a strong predictor of returns for most large-cap stocks. However, it is a good predictor of future volatility and downside performance, at least in the short term. This risk reduction is the principal source of low-volatility stocks' attractive risk-adjusted performance. But there are still risks worth watching.

Low-volatility stocks tend to be more sensitive to interest-rate changes than most. Part of this owes to tilts toward highly indebted utilities and REITs, but there's more to the story. Interest rates don't change in a vacuum. They tend to rise as the economy strengthens and fall as it weakens. Low-volatility stocks are less cyclical than most, so they have less cash flow growth to offset the negative impact of rising rates. Despite this risk, low-volatility stocks should still offer attractive risk-adjusted performance over the long term. It is also worth noting that this fund is a bit less sensitive to interest-rate risk than its peers that directly target low-volatility stocks.

The fund's performance relative to the MSCI USA Index has historically been positively correlated with the MSCI USA Value Index's, even though it explicitly limits its tilt toward value or growth stocks. This constraint helps mitigate unintended style bets, though it doesn't eliminate them entirely.

Not surprisingly, the fund has greater exposure to defensive sectors, such as utilities and consumer defensive, than the MSCI USA Index. It also has greater exposure to the real estate sector and less exposure to more-volatile sectors like energy and technology. The fund's sector constraints may prevent it from loading up on the least-volatile sectors, but they also better diversify risk.

Portfolio Construction The fund employs full replication to track the MSCI USA Minimum Volatility Index, which attempts to create the least-volatile portfolio with stocks from the MSCI USA Index. It earns a Positive Process Pillar rating because it uses a holistic approach to reduce volatility, applies reasonable constraints to preserve diversification, and emphasizes stocks that have historically offered superior risk-adjusted performance.

The index draws on the Barra Equity Model for estimates of each stock's volatility, exposure to risk factors, and the covariances between them. Notably, the model uses each stock's factor exposures, rather than its actual returns, to estimate its volatility and covariances. However, this choice probably doesn't have a big impact on the composition of the portfolio. The risk model places greater emphasis on more-recent data, which is likely more predictive of future risk. MSCI feeds this data into an optimizer that builds the portfolio expected to have the lowest volatility, subject to several constraints designed to improve diversification. These constraints keep stock weightings between 0.05% and 1.50% of the portfolio, sector weightings within 5% of the MSCI USA Index, and one-way turnover limited to 10%. The algorithm also applies constraints to limit tilts to other factors, such as value. The index is reconstituted semiannually in May and November.

Fees BlackRock charges a low 0.15% expense ratio for this offering, making it one of the cheapest defensive equity funds available. Therefore, it earns a Positive Price Pillar rating. Over the trailing three years through August 2019, the fund lagged its benchmark by 19 basis points annually, slightly more than the amount of its expense ratio.

Alternatives Invesco S&P 500 Low Volatility ETF SPLV (0.25% expense ratio) offers greater style purity than USMV but tends to make more-concentrated bets. Each quarter, SPLV ranks the stocks in the S&P 500 by their volatility over the past year. It targets the least-volatile 100 stocks and weights them by the inverse of their volatility, so that the least volatile stock receives the largest weighting. There are no constraints on sector weightings or turnover, which can be high. For these reasons, it earns a Bronze rating, one peg lower than USMV's.

SPDR SSGA US Large Cap Low Volatility Index ETF LGLV (0.12% expense ratio) takes a sector-relative approach to stock selection. It targets stocks with the lowest volatility in each sector over the past five years and weights them by the inverse of their volatility. This longer look-back period, coupled with the fund's infrequent annual rebalancing, will make it slower to adjust than SPLV as stocks' volatility relative to their peers changes.

Silver-rated Vanguard Global Minimum Volatility VMVFX (0.23% expense ratio) attempts to construct the least-volatile global-stock portfolio possible, using a constrained optimization approach similar to USMV's. It invests in both U.S. and non-U.S. stocks, yielding better diversification opportunities that can reduce portfolio volatility. While this is a rules-based strategy, it does not track an index, giving the managers flexibility to better manage transaction costs. They use forward contracts to hedge the fund's currency exposure.

1) Gandel, S. 2019. "2 Big Volatility ETFs Have Very Different Approaches." Barron's. Aug 30, 2019. https://www.barrons.com/articles/how-to-choose-a-volatility-etf-51567200240?

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