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Low Vol U.S. Equity ETFs: 5 Risk Weighted Offerings

Summary This article examines 5 ETFs that strive to offer lower volatility and downside protection against the broad U.S. equity market. Each of the 5 ETFs considers prior volatility in selecting and weighting constituents. Three performance criteria and fees are analyzed. This article will examine 5 low/minimum volatility ETFs tracking indices whose goal is to create less risky portfolios in relation to their cap weighted equivalent. The way each underlying index builds a portfolio differs, but the common theme is that they use some measure of volatility as the sole basis for portfolio construction (with the exception of things like maximum weight for a stock and sector constraints). Selected constituents are then weighted based on their prior volatility, not their market cap. The recent market selloff of August and September provides us with some real life data for these funds. The oldest ETF discussed here is less than 5 years old, so real life data is limited. Although most of the underlying indices tracked go back farther, we will limit our analysis to their ETF manifestations and avoid back-tested un-investable indices. The following table introduces the ETFs with some basic information. They will be compared to the S&P 500, represented by the Vanguard S&P 500 ETF (NYSEARCA: VOO ). Name Ticker Inception AUM MER Vanguard S&P 500 ETF VOO September 7, 2010 $39.56 billion 0.05% PowerShares S&P 500 Low Volatility ETF SPLV May 5, 2011 $5.12 billion 0.25% iShares MSCI USA Minimum Volatility ETF USMV October 18, 2011 $6.82 billion 0.15% SPDR Russell 1000 Low Volatility ETF LGLV February 20, 2013 $30.16 million 0.12% iShares MSCI USA Size Factor ETF SIZE April 16, 2013 $201.90 million 0.15% Janus Equal Risk Weighted Large Cap ETF ERW July 29, 2013 $2.57 million 0.65% Source: Morningstar.com on November 27, 2015 A consideration of the methodologies and some basic portfolio characteristics will provide insightful background before we begin our analysis. The source for the methodology information is the respective ETF provider and underlying index provider websites. Vanguard S&P 500 ETF Methodology: The S&P 500 tracks 500 large U.S. companies that are weighted on a float-adjusted market cap basis. Probably the most popular benchmark in the world, we will use VOO as our benchmark and consider the ETFs in relation to it. Top Holdings Weight Apple Inc (NASDAQ: AAPL ) 3.70% Microsoft Corp (NASDAQ: MSFT ) 2.29% Exxon Mobil Corporation (NYSE: XOM ) 1.87% General Electric (NYSE: GE ) 1.59% Johnson & Johnson (NYSE: JNJ ) 1.52% Source: Morningstar.com on November 27, 2015 PowerShares S&P 500 Low Volatility ETF Methodology: The 100 stocks from the S&P 500 with the lowest standard deviation over the prior 252 trading days are weighted by the inverse of their volatility (lower volatility stocks get higher weights). Rebalancing and reconstitution occurs in February, May, August, and November. Top Holdings Weight Plum Creek Timber Co Inc (NYSE: PCL ) 1.26% Coca-Cola Co (NYSE: KO ) 1.26% Airgas Inc (NYSE: ARG ) 1.22% Clorox Co (NYSE: CLX ) 1.22% Waste Management Inc (NYSE: WM ) 1.16% Source: Morningstar.com on November 27, 2015 iShares MSCI USA Minimum Volatility ETF Methodology: Not much detail is given for the construction of the underlying MSCI index. We do know that the index is constructed using the proprietary Barra Optimizer to achieve the lowest absolute volatility with a certain set of constraints. The constraints include minimum and maximum constituent weights and sector weights relative to the original MSCI USA index. Rebalancing occurs in May and November. Top Holdings Weight McDonald’s Corp (NYSE: MCD ) 1.74% AT&T Inc (NYSE: T ) 1.66% Public Storage (NYSE: PSA ) 1.64% Paychex Inc (NASDAQ: PAYX ) 1.52% PepsiCo Inc (NYSE: PEP ) 1.49% Source: Morningstar.com on November 27, 2015 SPDR Russell 1000 Low Volatility ETF Methodology: Up to 200 stocks from the Russell 1000 with the lowest standard deviation over the past 252 trading days are weighted by the inverse of their volatility. Rebalancing occurs monthly. Top Holdings Weight Home Depot (NYSE: HD ) 2.17% Henry Schein Inc (NASDAQ: HSIC ) 2.10% Aflac Inc (NYSE: AFL ) 2.07% McDonald’s Corp 2.06% Travelers Companies Inc (NYSE: TRV ) 2.06% Source: Morningstar.com on November 27, 2015 iShares MSCI USA Size Factor ETF Methodology: This ETF tracks the MSCI USA Risk Weighted Index. The index considers the variance of the 3-year weekly historical local return of the MSCI USA Index. The weighting is computed as the ratio of the inverse of the security variance to the sum of the inverse of the security variances of all constituents in the parent index. Rebalancing occurs in May and November. Top Holdings Weight Synchrony Financial (NYSE: SYF ) 0.68% Chubb Corp (NYSE: CB ) 0.57% Arch Capital Group Ltd (NASDAQ: ACGL ) 0.53% Clorox Co 0.50% PepsiCo Inc 0.49% Source: Morningstar.com on November 27, 2015 Janus Equal Risk Weighted Large Cap ETF Methodology: Beginning with the S&P 500, stocks are weighted using a proprietary method such that the expected risk contribution of each stock is equal. Rebalancing occurs in January, April, July, and October. Top Holdings Weight Best Buy Co Inc (NYSE: BBY ) 2.43% L Brands Inc (NYSE: LB ) 1.67% Sysco Corp (NYSE: SYY ) 1.48% Motorola Solutions Inc (NYSE: MSI ) 0.88% Keurig Green Mountain Inc (NASDAQ: GMCR ) 0.86% Source: Morningstar.com on November 27, 2015 The sector makeup of the six ETFs differs substantially. Relative to the S&P 500, an underweight to energy and technology and overweight to basic materials, real estate, consumer defensive, and utilities are present in all of the low volatility ETFs. Sectors VOO SPLV USMV LGLV SIZE ERW Cyclical Basic Materials 2.79% 4.50% 3.46% 3.12% 4.43% 4.69% Consumer Cyclical 11.49% 3.10% 7.13% 5.89% 12.43% 18.55% Financial Services 14.97% 17.23% 10.75% 19.81% 18.85% 9.91% Real Estate 2.13% 6.71% 7.78% 12.75% 6.42% 4.61% Sensitive Communication Services 4.19% 4.10% 5.89% 5.82% 2.89% 2.42% Energy 7.11% 0.00% 2.52% 0.83% 3.60% 6.38% Industrials 10.96% 19.69% 9.44% 16.40% 14.02% 13.23% Technology 18.76% 0.00% 9.79% 5.68% 9.42% 11.51% Defensive Consumer Defensive 9.61% 20.13% 15.60% 11.97% 10.61% 11.54% Healthcare 15.05% 13.38% 19.80% 14.11% 9.78% 9.48% Utilities 2.93% 11.16% 7.84% 3.61% 7.54% 7.67% Source: Morningstar.com on November 27, 2015 The following holdings overlap matrix shows that these different approaches result in significantly different underlying holdings, even though the methodologies may seem similar. Holdings VOO SPLV USMV LGLV SIZE ERW VOO 100% 26% 38% 27% 50% 49% SPLV 26% 100% 43% 42% 29% 22% USMV 38% 43% 100% 35% 36% 25% LGLV 27% 42% 35% 100% 18% 12% SIZE 50% 29% 36% 18% 100% 66% ERW 49% 22% 25% 12% 66% 100% Source: ETF Research Center Overlap Analysis The correlation between them is noteworthy in that it is somewhat close to 1 with the exception of ERW. Correlation VOO SPLV USMV LGLV SIZE ERW VOO 1.00 0.85 0.93 0.90 0.96 0.33 SPLV 0.85 1.00 0.95 0.94 0.92 0.45 USMV 0.93 0.95 1.00 0.93 0.96 0.39 LGLV 0.90 0.94 0.93 1.00 0.94 0.46 SIZE 0.96 0.92 0.96 0.94 1.00 0.41 ERW 0.33 0.45 0.39 0.46 0.41 1.00 Source: Yahoo! Finance, monthly returns based on adjusted closing prices, 8/1/2013-10/31/2015 Evaluation Criteria Now that we have reviewed some of the basics, it is time to take a closer look at these ETFs in the context of past performance, with emphasis on their behavior in negative market periods. The measures chosen for evaluation are an attempt to answer the question: “What does an investor who chooses a low volatility fund care about?” The funds will be evaluated based on three performance criteria and their fees: Risk-adjusted returns relative to the S&P 500 as represented by VOO Up and down period performance relative to VOO Performance in periods where the S&P 500 faced a significant drawdown Fees Methodology: I used adjusted closing prices (adjusted for both dividends and splits) from Yahoo! Finance. Since this uses prices and not the NAV of the funds, I think it skews some of the results, mainly for the small and thinly traded ERW. With low volume, the underlying value of the fund’s holdings can deviate from its last traded price materially. This likely explains its low correlation to the other ETFs as well. Although prices describe the real investor experience, I would keep this in mind when evaluating the results, with particular emphasis on ERW. Criteria 1: Risk-adjusted returns relative to the S&P 500 as represented by VOO Low volatility ETFs should be held to a standard of exhibiting lower standard deviation than their relevant benchmark. However, the return side is important as well. If a fund produces low volatility but also low returns such that the risk-adjusted return is lower, the investor would have been better off holding the benchmark and some cash. We will divide the annualized return by the annualized standard deviation to determine risk-adjusted returns. This is essentially a Sharpe ratio, but ignores the risk free return because short term cash yields are so low (under 0.10% for 3 month T-bills for most of the period under examination). ETFs with a higher/lower value than VOO will receive a pass/fail on this criterion. VOO SPLV USMV LGLV SIZE ERW Return 11.72% 10.55% 12.51% 11.67% 11.50% 8.11% Std Dev 11.32% 10.42% 9.39% 10.53% 10.04% 7.62% Return/Std Dev 1.04 1.01 1.33 1.11 1.15 1.06 Result Fail Pass Pass Pass Pass Source: Yahoo! Finance, annualized monthly data based on adjusted closing prices, 8/1/2013-10/31/2015 Every fund exhibited lower standard deviation over the period examined. USMV even achieved higher returns, a nice bonus and a help in driving its return/standard deviation figure to be the highest of the bunch. Although SPLV managed a lower standard deviation than VOO, it was more than offset by its weaker performance. ERW is a concern here. The return of the fund is the lowest by far, and the only in single digits. In addition, its lack of trading volume has likely understated the true standard deviation of the NAV of the fund. The numbers say it still gets a pass, but extra caution should be placed on its results. Criteria 2: Up and down period performance relative to VOO This measure will provide detail on how the ETFs do in up and down periods. The ideal low volatility fund doesn’t go down very much in market declines but can hang in the market rallies. A passing grade will be given to a fund that outperforms in more than half of the months in which VOO had a negative return. The percentage outperformance in positive months for VOO will be presented as well, but will not be scored. Months SPLV USMV LGLV SIZE ERW Outperformance vs. VOO in up months 17 41% 35% 47% 41% 12% Outperformance vs. VOO in down months 10 80% 70% 80% 60% 100% Result Pass Pass Pass Pass Pass Source: Yahoo! Finance, monthly returns based on adjusted closing prices, 8/1/2013-10/31/2015 All funds outperformed more than half of the time against negative return months for the S&P 500 ETF. It is noteworthy that USMV had a higher return with lower standard deviation over the period (see Criteria 1) than VOO despite only outperforming in roughly a third of positive months and 70% of negative months. In contrast, both SPLV and LGLV had better up and down performance but lower returns than VOO. Clearly, this metric doesn’t tell the whole story, but is helpful in assessing tendencies of relative performance as the broader market goes through positive and negative periods. Criteria 3: Performance in periods where the S&P 500 faced a significant drawdown Since the time period in question is relatively short, there aren’t any decreases in VOO that are particularly steep. Regardless, we will examine the three largest drawdown periods since August 2013. This deeper look into the magnitude of out or underperformance relative to the benchmark will focus on performance when it matters most for low volatility investors. Three months stick out since August 2013. The total losses in each month aren’t particularly deep, but the lowest points in each drawdown are significant. To pass, the ETF in question will need to both outperform and have a smaller maximum drawdown in at least two of the three months. Intraday high and low prices for the respective month will be considered in determining the maximum drawdown. VOO SPLV USMV LGLV SIZE ERW August 2013 Month Return -3.08% -5.04% -3.26% -4.71% -3.30% -3.03% Drawdown -4.65% -6.19% -4.43% -6.26% -4.35% -4.25% January 2014 Month Return -3.53% -2.57% -3.04% -1.61% -1.95% -1.88% Drawdown -4.34% -3.53% -3.83% -2.89% -2.81% -3.23% August 2015 Month Return -6.14% -5.01% -4.53% -6.18% -5.59% -4.56% Drawdown -13.25% -48.35% -38.18% -8.96% -9.59% -6.95% Result Fail Fail Fail Pass Pass Source: Yahoo! Finance, monthly returns based on adjusted closing prices, 8/1/2013-10/31/2015 The August 2015 numbers may have caused a double take. It is well known that the carnage of August 24, 2015 brought many ETFs down well below their NAVs. Although it didn’t take long for the massive discounts to correct themselves, this experience highlights a real concern for ETF investors. Anyone caught with a stop loss or market order sell would have been at risk for a nasty surprise. Interestingly enough, it was the two largest ETFs that were affected. Only SIZE and ERW managed to pass this test. The August 2013 drawdown was particularly challenging for the group, while the opposite is true for the one in January 2014. Besides the deviation between price and NAV for SPLV and USMV, the August 2015 drawdown provides positive evidence of the effectiveness of low volatility strategies. I would be inclined to give more value to this drawdown, as it was significantly larger than the other two. Criteria 4: Fees Nothing eats away at returns quite like fees. The table below takes a look at several factors that will affect how expensive these funds are to hold and trade. VOO SPLV USMV LGLV SIZE ERW MER 0.05% 0.25% 0.15% 0.12% 0.15% 0.65% Average Volume 2,000,000 1,500,000 1,200,000 3,632 12,475 1,064 Spread 0.02% 0.03% 0.05% 0.49% 0.21% 1.19% Premium/Discount -0.09% -0.07% -0.07% 0.33% -0.31% -0.82% Result Pass Pass Pass Pass Fail Source: Morningstar.com on November 27, 2015 Fortunately, most of the ETFs are very reasonably priced, even against the super cheap VOO. Only ERW’s expense ratio is uncomfortably high. The spread and discount are also troublesome, although not entirely surprising given the small assets of the ETF. All in all, fees need only be a consideration for those interested in ERW. Although it would be nice to see SPLV come down to the 0.15% range, all four other ETFs are priced fairly. The spread and discount may seem a little high on some of the ETFs in the table, but keep in mind I was taking these down on a holiday shortened trading day, so they are likely understating the liquidity of a regular trading day. Conclusion Examining the four criteria gave valuable insight beyond the basic characteristics of the ETFs. SIZE was the only ETF to pass all four criteria. SPLV was the only to fail two, while the remaining three ETFs failed one each. Criteria SPLV USMV LGLV SIZE ERW 1. Risk-adjusted returns Fail Pass Pass Pass Pass 2. Up and down performance Pass Pass Pass Pass Pass 3. Drawdown performance Fail Fail Fail Pass Pass 4. Fees Pass Pass Pass Pass Fail Does this mean I think SIZE is the best of the bunch and should outperform the others in the future, at least in negative market environments? I would hesitate to go that far. For one, the available data only goes back a few years and doesn’t include many strong drawdown periods. However, based on the characteristics of the funds and the behaviour exhibited in our examined timeframe, I would feel comfortable using a low volatility product in a supporting capacity within the U.S. equity allocation of a portfolio. These products may be even more appropriate for somebody who is concentrated in a sector that is underrepresented in the funds, such as energy or technology. The only ETF I have reservations about is ERW. This small ETF trades thinly, with high bid ask spreads and a high expense ratio. It has done well in the performance criteria but this was influenced by the fact that we were looking at prices and not NAV. With ERW not trading some days and having low volume on the others, sizable discounts and premiums are common. I have nothing against the methodology of the underlying benchmark, but unless liquidity improves, it would be hard to place it above any of the other options. My recommendation is to consider combining any of SPLV, USMV, LGLV, or SIZE within your U.S. equity allocation. Of those four, there is no clear winner at this point. I will leave it to the reader to choose among them, and they are certainly differentiated in sector allocation, holdings similarity, and correlation. I deem all four suitable for lowering volatility and protecting on the downside as part of a larger U.S. allocation in a portfolio. Disclaimer: This article was not intended to be taken as investment advice. Please conduct due diligence of any ETF investment you are considering, including but not limited to a review of the prospectus, underlying benchmark methodology (if applicable), portfolio characteristics, holdings, performance since inception, role in your existing portfolio, and outlook for future performance.

Whatever You Do, Avoid Major Mistakes

As we all well know, the surest way to derail a reasonable investment plan is to make a major mistake. Avoiding major mistakes begins with identifying multiple reasons to invest and is bookended with diversification. When wishful thinking overtakes a thoughtful approach to investment decision-making it is time to step back. I can’t imagine any investor – no, not even Warren Buffett – who hasn’t occasionally banged their head on the wall grumbling, ‘Why the #@&% did I do that?’ The last decision that I regret was getting over-concentrated in chemical companies not fully appreciating that they could get hit by declining petroleum prices. Fortunately, I caught myself early but the mistake set back my returns somewhat; arghhh. Buy for Multiple Reasons Five weeks ago in my first article on Seeking Alpha, I said, “[A] strategic approach to investing, combined with fundamental and technical analysis, has served me well; it holds the potential for alpha-level returns.” Well, the inverse of reward is risk and that is why this philosophy also points to the three levels of protection I seek in every stock I own. I buy for multiple reasons believing that I can be wrong on any one but that it is unlikely that I will be wrong on most or all: Invest into big, developing, scientific, socio-economic, and political patterns and trends that have not yet been reflected in the price of related equities. Trends like the 2014 Congressional shift and escalating global tensions that pointed the way to the end of sequestration and increased military spending with all the promise that holds for major defense contractors. Find companies with fortress fundamentals including rising revenue or the promise thereof, solid margins and earnings, strong cash flow from operations right on down to free cash flow, and a great balance sheet. Guard against overpaying technically. I am not a chartist and, frankly, I think a lot of it is voodoo. That said, there are a lot of institutional analysts and investors out there following this blip or that, interpreting tops and bottoms, fixated on second derivatives, you name it. Like it or not, good investors must be attentive to such things and so I always touch base with a technician before making any move. Think Broader about Diversification The other bookend of protection is diversification and this means more than simply owning a bunch of different investments. It means diversifying by industry sector, instrument type, and geo-politically. Industry sector diversification is fairly obvious. Anyone who was heavily into oil/gas and ores/metals over the last year got crushed. I myself have unrealized losses on two positions I hold in major integrated petroleum companies. However, those paper losses are relatively small because of the downstream/retail operations of these firms. In other words, the two oil firms I hold are diversified themselves. The setback is not enough to pull them under or to sink my alpha-level performance what for the decisions I have made in other sectors. The same cannot be said for investors over-exposed to shale production or deep sea drilling. As to instrument type, I am less disciplined. I sit on a 12-month supply of cash, own a house and a piece of a farm, and have directed that my charitable donor-advised fund be split 50:50 between equities and bonds. But that aside, today I am a stock guy; I do not hold bond or bond-proxy investments including preferreds or REIT’s. Occasionally, I will buy an option to gain leverage on a strong hunch, but not often. Competent financial advisors recommend a mix of products and it is well to follow their advice. For myself, if interest rates were nearing the end of a secular up-turn, I would plow money into bonds and bond-proxies, but not now. I have made a conscious decision not to diversify at this time into those types of investments. I am, however, a big believer in geo-political diversification. With some exception, most Seeking Alpha contributors and commentators are fixated on US investments. In general, they avoid discussing foreign bond or equities including in the form of ADR’s. Take five minutes to do a quick scan of the articles now trending on Seeking Alpha and you will see what I mean. This is unfortunate because just as individual investments, industry sectors, and instrument types go up and down, so do countries. Indeed, if the Fed finally raises interest rates it will have a deleterious effect on almost all US investments. However, the move could be very positive for some foreign investments including companies that heavily export to the US. I own such companies as a part of my diversification strategy; I am especially partial to transnational companies. Therefore, one way to avoid major mistakes is to diversify beyond just individual investments along vectors. Here are the number of stock positions I hold by sector x country. As you can see, my investments cover 9 industries with fully one third of my holdings in companies headquartered outside the United States (the number of positions I hold are proportional to the dollar amount of my holdings): Sector # Positions U.S. U.K. France Switzerland Japan Ag/Food 3 3 Autos 3 3 Defense 4 4 Energy 2 1 1 Financials 5 2 3 Pharma 6 5 1 Other Mfg. 2 2 Tech 2 2 Water 2 2 Total 29 19 1 3 3 3 In passing, I’d like to mention what I will call “crosstab risk management”. This topic interests me from my days doing business in the old Eastern Europe financing the likes of East Germany, the Deutsche Demokratische Republik. The DDR in the 1980’s was a financial disaster; I recall a business lunch at the Deutsche Aussenhandelsbank in which we were served toast, lard and charged water. Still, we did good safe business there because we confined our investing to short-term trade finance – bankers’ acceptances – as we did with other Comecon and Latin American “LDC” (lesser developed countries) at the time. In other words, we carefully selected a specific instrument type to apply to these very difficult geo-political circumstances. There are other special types of risks that also interest me. As but one example, dating back to my days financing commodity companies, I became very interested in counter-party risk which equates to default risk as defined by the inability of a party to live up to its contractual obligations. This type of risk can wreak havoc on highly-leveraged commodity production and trading companies because it can ricochet through the system with breathtaking speed. Its discussion is outside the scope of this article. However, given serious dislocations among shale frackers and smaller mining companies, investors in those sub-sectors would be well-advised to study-up on counter-party risk. Step Back When It’s Time Denial is the hope or dream that something is right when it is really wrong. One of the great setups for this is in the analyst or pundit who says, ‘It has already lost all the value it’s going to lose; it’s time to jump in!’ Newsflash: Just because a stock has lost 50% of its market cap doesn’t mean that it can’t lose another 50% of what’s left. Anyone who wants to see a perfect example of this need only review past articles and comments on SA about North Atlantic Drilling Company (NYSE: NADL ). Here is stock that in just over a year lost 90% of its value 50% at a time. National Bank of Greece (NYSE: NBG ) is another striking example. When wishful thinking begins to overtake a thoughtful approach to investment decision-making, it is time to step back. It’s time to take a zero-based approach to your holding(s) and diversification strategy. If nothing has really changed, stay the course. If things have changed materially, sell, take your lumps, move on, and don’t look back. This is the same philosophy that accomplished executives take with M&A’s gone bad. Which brings me to a final word on reward. People have a right to ask, ‘How can you possibly generate alpha-level returns from spreading yourself across 29 positions?’ It’s a good question and one I’ve asked of other contributors on SA who have offered no evidence that they generate even beta-level returns across their spectrum of ideas. I offer this answer: I’m not really spread all that thin. I focus first on potentially large developing patterns and trends and only then search out stocks to capitalize on them. So, I’m really investing in fewer big ideas. This is a lot different than a random walk or buying fund shares. On the other hand, if you don’t have the time, interest or expertise to take a more focused approach to portfolio management you’re better off finding someone who can including in the form of fund managers. Editor’s Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.

Black Friday sales data point to ‘Apple holiday season’

Christmas will be Apple (AAPL) scented this year, judging from Black Friday weekend sales. “It’s an Apple holiday season — it’s all about iPhones, Apple Watch, iPads and Apple TV,” Global Equities Research analyst Trip Chowdhry said in a research report Saturday. Apple is being helped by expanded availability of its products through retail partners including Best Buy (BBY), Costco (COST), Staples (SPLS), Target (TGT) and Wal-Mart (WMT), he said.