U.S. investors who entrusted $40 billion to stock-picking computers are having some pretty lousy luck.
Several multi-billion-dollar exchange-traded funds that are billed for their low volatility have been anything but in recent days after rebalancing into a record amount of technology shares. Suddenly, they’re cauldrons of turbulence after a three-week span in which computer and Internet stocks went from the market’s standard-bearers to its worst performers.
Just yesterday, tech shares led the S&P 500 Index to its worst drop in six weeks. Fortresses of calm three months ago, low-vol’s newly minted members are behaving badly.
“Macro events, political news, sector actions, they can all come in and sucker punch some of these factor ETFs,” Eric Balchunas, an ETF analyst for Bloomberg Intelligence, said by phone. “Investors need to ask themselves, how much of the factor do I really want here? If you want more of the factor, you’re going to have to take more of the sectors and probably more volatility.”
Providers often tout low volatility as a risk mitigating strategy: buy the fund and you’ll get most of the market’s upside with less downside. And while a few days’ price action means nothing for the concept’s viability, that’s not what’s been happening of late. Weighed down by tech, the PowerShares S&P 500 Low Volatility Portfolio, or SPLV, dropped 1.1 percent Thursday for the biggest daily drop in more than six months. The iShares’s MSCI Min Vol USA ETF, or USMV, fell 1 percent, its most since November.
The $14 billion PowerShares and $6.9 billion iShares products are two of the most popular low volatility ETFs. Both rebalanced last month, pumping up technology to 11 percent of SPLV’s holdings and 18 percent for USMV, the most since their inception in 2011. USMV tends to hold more technology stocks, since it’s built to never deviate more than 5 percent from the broader market’s sector weightings.
Back when volatility was nowhere to be found, the ETFs had an endless supply of quiet stocks to chose among. Flocking to tech initially paid off. The ETFs posted record highs following the rebalance, with SPLV beating out the S&P 500 by more than 1 percentage point last month.
Now, there are hints of turbulence creeping back into the market. Unfortunately for low-vol, it’s been concentrated in technology megacaps. The Nasdaq 100 Index’s implied volatility gauge averaged 15.1 in June, hitting levels that represented its biggest gap to the S&P 500’s implied volatility since the financial crisis.
USMV and SPLV both hold Google parent Alphabet Inc. and Microsoft Corp., which fell as much as 2.4 percent Thursday.
More tech tantrums will spell trouble for the low volatility funds. With rebalances scheduled on a quarterly or semi-annual basis, they’re committed to tech for at least the next two months. A similar contamination happened last year, when low-vol and momentum stocks became closely correlated, sideswiping the latter when momentum skidded out in the fourth quarter.
For now the factor overlap isn’t an imminent concern. Both SPLV and USMV have negative exposures to momentum, according to Bloomberg PORT. What’s more, yesterday’s pain is no big deal for investors planning to hold the ETFs over an extended period of time to smooth out the market’s moves, said Balchunas.
“For people who believe in holding it for a long period of time, this is probably meaningless,” he said. “If you tried to time low-vol and it got hit with a tech sell-off, you’re probably not happy.”