Setting up for a Low Vol Heartbreak?

Despite the record highs the S&P 500 made last week, the market rally that began so powerfully on such depressed momentum in mid-October seems to be maturing.  With a light Veteran’s Day helping set-up the weakest weekly volume since mid-September, behind the scenes sector rotation helped keep the overall breadth healthy and took pressure off some of the more “defensive” sectors that have carried the load so far in the 4^th quarter.  Healthcare and Consumer Staples lagged the broader market while financials and REIT’s saw slight declines as Utilities pulled back on strong selling pressure.  Could sector rotation be setting up one of the most popular ETF asset gather’s for some serious heartbreak?

Currently, iShares MSCI USA Minimum Volatility ETF (USMV) has the lowest ranked volatility of any ETF we track with our Red Diamond Risk Ratings.  Having grown to over $350 billion, 2014 might be remembered as the year of the “Smart Beta” ETF with one of the most popular strategies being low volatility.  Along with the PowerShares S&P 500 Low Volatility Portfolio (SPLV), USMV gathered hundreds of millions in new assets while outperforming the S&P 500 in 2014 - SPLV has performed in-line with the broader market, but as their names implied, both did so with less volatility and significantly less drawdown.

The secret to their success is being concentrated in large cap stocks with a strong focus on the traditionally defensive sectors that have powered the market higher in 2014, but that success put the funds in “expensive camp.”  Both are trading at levels that have pushed their ETFG Quant Fundamental Scores down to among their lowest levels with USMV trading at a trailing P/E of 25.23 and SPLV at 23.49 versus 19.32 for the iShares Core S&P 500 (IVV) and pushing their ETFG Green Diamond Reward rankings into the “Underperform” zone.

Even with large cap stocks continuing to hold their ground despite the weakness in small and mid-cap names, one of the chief concerns over USMV and SPLV is their mutual heavy exposure to those sectors that have enjoyed the strongest performance in 2014 and have seen recent weakness as the market rally matures.  SPLV currently has over 20% of its assets concentrated in the utilities where the Utilities Select Sector SPDR fund dropped 2.83% last week amid a clear loss of momentum against the S&P 500 and picking up only slightly more than 50% of the market’s gain in the last month.  USMV has more marginal exposure to utilities, but has its largest sector positioning in healthcare care names, currently 17.9% of the portfolio - leaving it vulnerable in the event that recent blip in relative performance extends into the New Year.  Both funds share a large concentration towards consumer staples names at about 15% of their respective assets.

While we at ETFG will be the first to applaud the development of new ETF products and tools to help investors expand their range of portfolio options, that doesn’t mean we won’t encourage you to do your research first.  Investors seeking low volatility and a high Sharpe ratio haven’t been disappointed with these funds so far in 2014, but is their good fortune about to change?

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