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Low Volatility Funds Outperform In 2016

In July and August of 2015, I wrote an expansive series of fourteen articles on the Low Volatility Anomaly, or why lower risk investments have outperformed higher risk investments over time. This Anomaly seems paradoxical; investors should be paid through higher returns for securities with a greater risk of loss. Across different markets, geographies, and time intervals, the series shows that higher beta investments have not delivered higher realized returns and offers suggestions backed by academic research to suggest why this might be the case. We are in another period where lower volatility stocks are dramatically outperforming higher beta stocks, and this article will demonstrate the relative performance of these strategies year-to-date. I will demonstrate the relative performance across capitalization sizes (large cap, mid-cap, and small cap equity) and other geographies (international developed and emerging markets). Readers may counter that, of course, lower risk stocks are outperforming in a down market, so I will show relative performance of the indices underpinning these strategies back to the March 2009 cyclical lows. If lower volatility strategies capture less upside in bull markets, then perhaps their value in corrections is overstated. Let’s look at the evidence. Year-to-Date Performance: Large-Cap Thus far in 2016, the two most popular low volatility exchange-traded funds, the iShares MSCI USA Minimum Volatility ETF (NYSEARCA: USMV ) and the S&P 500 Low Volatility Portfolio (NYSEARCA: SPLV ) are handily beating the S&P 500 (NYSEARCA: SPY ), the broad domestic equity market gauge. Through Friday’s close, the S&P 500 has generated a -8.46% total return while the most popular low volatility funds have lost just over three percent. Relative performance is graphed below: Click to enlarge Source: Bloomberg; Standard and Poor’s Year-to-Date Performance: Mid-Cap Mid-cap stocks have further underperformed large cap stocks thus far in 2016 with the SPDR S&P MidCap 400 ETF (NYSEARCA: MDY ) producing a -9.57% return. The low volatility subset of this index, replicated through the PowerShares S&P MidCap Low Volatility Portfolio (NYSEARCA: XMLV ) has also meaningfully outperformed in 2016, besting the mid-cap and large cap indices. For a historical examination of the risk-adjusted returns of this index, see my article on ” The Low Volatility Anomaly: Mid Caps “. Click to enlarge Source: Bloomberg; Standard and Poor’s Year-to-Date Performance: Small Cap Like both large and mid-cap stocks, the PowerShares S&P SmallCap Low Volatility Portfolio (NYSEARCA: XSLV ) has meaningfully outperformed the S&P 600 SmallCap Index ETF (NYSEARCA: IJR ). While the exchange-traded fund has a limited history (February 2013 inception date), the underlying index has data back for twenty years, demonstrating a return profile that would have bested the S&P 500 by nearly four percentage points per annum with lower variability of returns. This fund may deliver both the “size premia” and the “low volatility anomaly” in one vehicle, and has acquitted itself decently (543bp outperformance versus small caps and 307bp outperformance versus the S&P 500) in a rough market start to 2016. For a historical examination of the risk-adjusted returns of this index, see my article on ” The Low Volatility Anomaly: Small Caps “. Click to enlarge Source: Bloomberg; Standard and Poor’s Year-to-Date Performance: International Developed Negative equity market performance has obviously not been unique to the United States amidst a global sell-off. The PowerShares S&P International Developed Low Volatility Portfolio (NYSEARCA: IDLV ) has outperformed non-US developed markets, besting the Vanguard FTSE All-World ex-US ETF (NYSEARCA: VEU ) by 450bp in 2016. Click to enlarge Source: Bloomberg; Standard and Poor’s Year-to-Date Performance: Emerging Markets Pressured by the spillover from decelerating Chinese growth, commodity market sensitivity, and increased market and currency volatility, emerging markets have been a focal point for stress in 2016, but the PowerShares S&P Emerging Markets Low Volatility Portfolio (NYSEARCA: EELV ) has meaningfully outperformed the two largest emerging market exchange traded funds – the Vanguard FTSE Emerging Markets ETF (NYSEARCA: VWO ) and the iShares MSCI Emerging Markets ETF (NYSEARCA: EEM ). Click to enlarge Source: Bloomberg; Standard and Poor’s In past articles, I have often demonstrated the efficacy of Low Volatility strategies by showing the relative outperformance of the S&P 500 Low Volatility Index (NYSEARCA: SPLV ) versus the S&P 500 and S&P 500 High Beta Index (NYSEARCA: SPHB ). The Low Volatility bent produces both higher absolute returns and much higher risk-adjusted returns. Click to enlarge Readers might look at these cumulative total return graphs and believe they can time the points at which high beta stocks outperform. From the close of the week at the cyclical lows in March 2009 to Friday’s close, the Low Volatility Index has also outperformed on an absolute basis. Click to enlarge In a long bull market that saw 16%+ annualized returns, you have not conceded performance when including the recent correction. In addition to less variable returns over time, low volatility strategies also afford more downside protection – an important feature that has been valuable in early 2016. Disclaimer: My articles may contain statements and projections that are forward-looking in nature, and therefore inherently subject to numerous risks, uncertainties and assumptions. While my articles focus on generating long-term risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance, and investment horizon. Disclosure: I am/we are long SPY, SPLV, USMV, VWO, IDLV, XSLV, IJR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

In Search Of The Rate-Proof Portfolio

After October’s better-than-expected employment report , a December Federal Reserve (Fed) liftoff is looking more likely than it was earlier this fall. In response, U.S. interest rates have been on the rise in recent weeks, with Treasury yields reaching their highest levels since July earlier this month, according to Bloomberg data as of November 13. Remember that bond prices fall as yields rise. While the long-term rise in rates is likely to be contained due to numerous factors, I expect rates will continue drifting higher even if the Fed doesn’t hike its fed funds rate next month. The central bank has made it clear that its first rate hiking cycle in nearly a decade is coming sometime soon , whether that’s December or next year. So, it may be a good idea to start preparing your portfolio for the upcoming rate regime change , one where rates are expected to moderately increase and remain below historical averages. While there’s no such thing as a fully rate-proof portfolio, there are some simple moves you can make now to help better insulate your investments from rising rates. Here are a few ideas to consider: Focus on U.S. stock market sectors that appear well-positioned for a rising rate cycle. Two sectors worth considering: U.S. technology and U.S. financials (excluding rate-sensitive REITs). First, they’re cyclical sectors which tend to outperform when the economy is strong, as is typical in a rising rate environment. In addition, technology companies may be poised to outperform other sectors amid higher rates, in large part due to their large cash reserves and strong balance sheets. With limited debt financing, they may be less vulnerable than debt-laden firms due to the higher borrowing costs that result when rates rise. As such, this sector has the potential for sustainable growth and continued shareholder friendly policies even as rates increase. Meanwhile, for some financial institutions, such as banks, higher rates could mean higher profits. In a rising rate environment, banks can potentially improve their net interest margins, as the difference between what they make from lending (their revenue) and what they pay for deposits (their costs) may increase. It’s no surprise, then, that according to Bloomberg data as of November 13, the performance of U.S. bank stocks has closely tracked the two-year U.S. Treasury yield, a proxy for investors’ expectations of short-term interest rates. Currently, as the data show, both measures are trending higher. You can read more about the case for these two sectors in my recent post, ” 2 Sectors to Exposure When Rates Rise .” Consider new sources of income . One such income source to consider: exposure to companies that have the potential to sustainably grow and increase dividends over time. So-called “dividend growers 1 look more reasonably priced than their high-dividend paying counterparts , according to Bloomberg data, and thus, could potentially outperform high dividend stocks in a rising-rate environment. A dividend growth strategy may also offer more exposure to cyclical sectors that have the potential to grow alongside the economy. Seek a better balance of risk and return . In other words, when it comes to preparing your bond portfolio for rising rates, consider reducing interest rate exposure while focusing on credit exposure. Shortening the duration of your bond portfolio can potentially help manage losses due to rising interest rates; low duration can potentially mean less volatility or price risk. At the same time, corporate bonds typically provide the potential for additional yield over Treasuries, so exposure to this asset class can be a way to generate income to help offset some of the impact of rising Treasury yields. For more on these two fixed income strategies, check out my recent post on ” Ideas for Your Bond Portfolio When Rates Rise .” I can’t guarantee that the above investing ideas will make your portfolio rate-proof ; however, these strategies can potentially help you reduce the negative impact of rising rates as well as help capture the opportunities presented by the new rate regime. Learn more about these strategies for rising rates, and the exchange-traded funds (ETFs) that can help you put them into action, at iShares.com. Funds that can provide access to these strategies include the iShares U.S. Technology ETF (NYSEARCA: IYW ) and the iShares U.S. Financial Services ETF (NYSEARCA: IYG ), which can provide exposure to the U.S. Tech and U.S. Financials ex-REITs sectors, respectively. Meanwhile, the iShares Core Dividend Growth ETF (NYSEARCA: DGRO ) is one way to access dividend growers, and ETFs, such as the iShares Floating Rate Bond ETF (NYSEARCA: FLOT ) and the iShares Ultrashort Duration Bond ETF (BATS: NEAR ), can help you shorten your duration, while the iShares 1-3 Year Credit Bond ETF (NYSEARCA: CSJ ) is among the funds that can aid you in gaining credit exposure. [1] a subset of dividend-paying stocks with the S&P 500 Index that increased their dividends anytime in the last 12 months. This post originally appeared on the BlackRock Blog.