Why these factor ETFs are underperforming the market

Low-volatility shares are supposed to outperform the market, but that has not been the case of late. 

One of the starting points for understanding investment performance is that more risk usually means potentially higher performance. Shares, for example, are riskier than bonds but they have provided, on average, higher returns. Risk here is defined as volatility.

However, there is also plenty of evidence and theory suggesting the opposite is the case. As Larry Swedroe writes in his book Your Complete Guide to Factor‑Based Investing: “Empirical studies have found that the actual relation [between risk/volatility and returns is] flat, or even negative.”

Swedroe continues: “Over the last 50 years, the most ‘defensive’ (low-volatility, low-risk) stocks have delivered both higher returns and higher risk-adjusted returns than most ‘aggressive’ (high-volatility, high-risk stocks).”

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The idea of low-volatility stocks providing higher returns was first identified by the academic Fischer Black in the 1970s. Since then several studies have demonstrated the outperformance of a basket of low-volatility stocks to a wider market benchmark over certain periods of time.

There are many potential explanations for the superior performance of low-volatility stocks. One of the most popular is the ‘lottery demand theory’. According to this idea, investors have a preference for stocks with lottery-like potential. Such stocks are usually higher volatility, leading investors to pay more for high-volatility stocks.

At the heart of most explanations is the idea that because of either market structure or the behavioural biases of investors, low-volatility stocks are less popular and therefore are ‘cheap’ and offer higher returns over time.

The problem, however, is that the low-volatility ‘factor’ has been failing to produce outperformance of late. On a one-year basis (as of 26 March 2021), the iShares Edge MSCI World Minimum Volatility ETF (LSE: MINV) has returned 8.4%, total return in sterling terms. The Xtrackers MSCI World Minimum Volatility ETF (LSE:XDEB) has produced roughly the same performance. Not bad. However, that’s way below the performance provided by the global index. For example, the iShares Core MSCI World ETF (LSE: SWDA) has returned just over 35%.

But this is not just the result of the past year of Covid-induced market volatility. On a five-year basis, both the iShares and Xtrackers minimum volatility ETFs have provided returns of around 55%. In contrast, the iShares Core MSCI World ETF returned 96%.

This underperformance of low-volatility stocks can be observed in other markets, too. When it comes to US stocks, the iShares S&P 500 ETF (LSE: IUSA) has a one-year total return of 35%. In contrast, the iShares Edge S&P 500 Minimum Volatility ETF (LSE:MVUS) has returned 20%. On a five-year basis, the standard S&P 500 ETF has provided a return of 116%, while the minimum volatility version provided just under 80%.

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Elsewhere, the iShares MSCI Emerging Markets ETF (LSE: IEEM) has provided a return of 38% over the past year and 80% over the past five years. Meanwhile, the iShares MSCI Emerging Markets Minimum Volatility ETF (LSE:EMMV) has returned 21% over one year and 45% over five years.

There are several possible explanations for this underperformance. First, the relative popularity of the minimum-volatility strategy may mean such stocks are now too expensive to provide the outperformance they have historically. As with all factors, its ‘discovery’ can lead to its benefit being ‘arbitraged’ away. Put simply, if investors know that low-volatility stocks provide better returns they will buy such stocks, pushing up prices and reducing future returns.

However, another explanation is so-called sector clustering. Factor-based investing is often at risk of this. Stocks that exhibit some common market characteristic often end up being in the same sector. So, for example, overrepresented in the MSCI Minimum Volatility index compared to the broader MSCI World index are utilities and consumer staples. Meanwhile, information technology is underrepresented. It is similar for other minimum volatility indices.

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Considering how markets have fared in recent years, therefore, the underperformance seems obvious. First, tech stocks have outperformed nearly everything, including consumer staples and utilities. So being underweight tech and overweight the other two sectors has been a drag on returns.

However, the sector-clustering explanation also blends into the ‘overpaying’ explanation. While utilities have underperformed tech in recent years, utility stocks became much more expensive relative to their historic valuations after the 2008 financial crisis. Due to historically low interest rates, investors looking for stable income increasingly moved into dividend-paying utility stocks, pushing up their prices and reducing potential future performance.