Are Low Vol ETFs as Smart as They Sound? July 27, 2017 [smart beta, low vol ETFS] – Josh Rubin Josh RubinAssociate Portfolio ManagerJosh Rubin is an associate portfolio manager for Thornburg Investment Management. He joined Thornburg in 2017 as a client portfolio manager, supporting the global strategies, and transitioned to his role as associate portfolio manager in 2018. Before joining Thornburg, Josh held several positions at Driehaus Capital Management in Chicago, including portfolio manager of the global, U.S. large-cap, and U.S. mid-cap equity strategies, and assistant portfolio manager responsible for emerging markets. Prior to Driehaus, Josh co-managed the emerging markets equity strategy at Marsico Capital Management in Denver, where he was also a senior analyst covering global companies across sectors. He began his career in finance as an investment banker in the fixed income division of George K. Baum & Company in Denver. Josh holds a BSFS in international politics from the Walsh School of Foreign Service at Georgetown University. “Smart Beta” ETFs and their low-volatility ETF progeny may deliver a lower beta against their relevant benchmarks, but they’re not immune to bouts of volatility, and their returns frequently come up short. How smart are “smart beta” products? As factor-based investing is the latest fashion in the allocation trend to passive exchange traded funds, the performance of the most popular among smart beta instruments—the low volatility ETFs—is worth a look. Do they deliver? Context is helpful in understanding both their longer- and shorter-term performance, as well their volatility against stock market benchmarks. In essence, passive investing is a bet on general economic progress and a belief that it’s too hard to sort out winners from losers. So future economic growth broadly lifting all corporate boats creates the return. Smart beta tries to take the bet a step further by using historical relationships in asset price movements to predict the direction of future price movements. That, of course, runs counter to the most frequently used compliance disclaimer in investment advertising: “past performance is no guarantee of future results.” Nonetheless, smart-beta employs backward-looking characteristics in a bid to differentiate the return—effectively, a stock was good before, so it will be good in the future. In the case of “low vol” ETFs, historically they have indeed delivered a beta, a measure of market-related risk, 20% to 25% lower than the relevant indices. But, this hasn’t come with differentiated total returns in recent measurement periods. In the U.S., the PowerShares S&P 500 Low Volatility Portfolio (SPLV) ETF and the iShares Edge MSCI Min Vol USA (USMV) ETF, both lagged the S&P 500 Index and the MSCI USA Index by roughly 30 to 50 basis points over the first six months of the year, and by nearly 1,000 basis points over the trailing one-year period. Although both beat the two U.S. indices in the three-year period, they badly lagged in the five-year timeframe. Underperformance in overseas developed, emerging and global segments is also mostly evident in the same measurement periods, again excepting the three-year timeframe outside of emerging markets. The three-year timeframe coincides with a period of trending markets and economic stability as central banks committed to mitigating economic and market volatility and risk. To be sure, lower beta is generally indicative of lower share price volatility. But there have also been short periods when low vol ETFs have had higher volatility than the overall market, failing at their core mandate. The key flaw with smart-beta products is that they are backward-looking, while markets are dynamic, driven by changes in consumer tastes, corporate strategy, and government policy—let alone the underlying forces of creative destruction. Imagine riding in a taxi with a driver insisting that he didn’t need the windshield, side windows or dashboard because everything important was visible in the rearview mirrors. Active managers, by contrast, utilize manifold views—including the rearview—and a multiplicity of instruments designed for forward-looking risk management in pursuit of differentiated upside capture. In effect, smart beta has delivered inconsistent performance across market environments because it is backward-looking with no predictive analysis built into its design. So downside protection among low vol ETFs has been mixed in market selloffs. On the flip side, they have underperformed in up-trend markets this decade because they seek to buy historical performance, but are always late to the game: they take too long to capture market rotations in their calculations and periodic rebalancing. They didn’t capture the Trump-bump or the European economic upswing rotations. As we move into a period where central banks step back from their recent efforts to provide market stability and to encourage risk taking, can low vol ETFs capture the market’s future dynamism just by looking backward? At a micro-level, low vol algorithms also don’t capture corporate turnaround stories or undervalued companies because they essentially assume the companies will always be broken and that laggards will always lag. But new management strategies frequently emerge and cyclicals don’t always lag. Interestingly, the design of the low vol products can come in handy for quantitative long/short equity strategies. Because an ETF’s structure and rebalancing dates are commonly known, hedge funds can get ahead of the fund flows from the periodic rebalancing. They can model which constituents are likely to be sold and bought on the rebalancing date. They can therefore play the flows by shorting the ETF’s expected sells and going long the ETF’s expected buys in advance of the rebalancing date. Front running an ETF rebalancing is not rocket science. “Smart beta” is catchy marketing. But low vol ETFs, like other factor-based ETF investing, don’t seem all that smart. Performance as of 6/30/2017 Name YTD 1-YR 3-YR 5-YR Since Inception Powershares S&P 500 Low Vol ETF (SPLV) Incp. 5/5/11 Expense Ratio 0.25% NAV 8.74% 6.73% 10.38% 12.90% 12.96% Market Price 8.86% 6.92% 10.43% 12.93% 12.98% S&P 500 Index 9.34% 17.90% 9.61% 14.63% 12.57% iShares Edge MSCI Min Vol USA ETF (USMV) Incp. 10/18/11 Expense Ratio 0.15% NAV 9.28% 8.13% 11.82% 13.51% 14.58% Market Price 9.21% 8.13% 11.82% 13.50% 14.58% MSCI USA Minimum Volatility (USD) Index* 9.40% 8.03% 12.00% 13.52% 14.28% MSCI USA Index* 9.53% 18.02% 9.42% 14.58% 15.34% iShares Edge MSCI Min Vol EAFE ETF (EFAV) Incp. 10/18/11 Expense Ratio 0.32% NAV 14.33% 9.04% 5.18% 9.63% 9.08% Market Price 15.34% 8.78% 5.20% 9.45% 9.13% MSCI EAFE Minimum Volatility (USD) Index* 14.65% 9.60% 5.60% 10.06% 8.78% MSCI EAFE Index* 14.22% 20.92% 1.73% 9.29% 8.25% iShares Edge MSCI Min Vol EM ETF (EEMV) Incp. 10/18/11 Expense Ratio 0.71% NAV 13.12% 10.53% -0.37% 2.98% 4.64% Market Price 14.22% 9.80% -0.26% 2.77% 4.66% MSCI EAFE Minimum Volatility (USD) Index* 13.50% 11.12% 0.11%% 3.36% 4.55% MSCI EM Index* 18.58% 24.17% 1.42% 4.30% 4.22% iShares Edge MSCI Min Vol Global ETF (ACWV) Incp. 10/18/11 Expense Ratio 0.32% NAV 9.70% 6.28% 8.29% 10.53% 10.86% Market Price 10.09% 6.09% 8.26% 10.38% 10.88% MSCI All Country World Minimum Volatility Index* 9.88% 6.70% 8.66% 10.81% 10.74% MSCI ACWI Index* 11.81% 19.45% 5.42% 11.17% 11.02% *Source: Bloomberg, Gross Index Returns. Annualized for periods longer than one year. Performance data shown represents past performance and is no guarantee of future results. Investment return and principal value will fluctuate so shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than quoted. For performance current to the most recent month end, please contact your financial advisor or visit ishares.com or powershares.com. Market returns are based on the midpoint of the bid/ask spread at 4 p.m. ET and do not represent the returns an investor would receive if shares were traded at other times. ETFs selected represent five most popular based on total assets. For more Global Perspectives read the previous article Important Information Before investing, carefully consider the Fund’s investment goals, risks, charges, and expenses. For a prospectus or summary prospectus containing this and other information, contact your financial advisor or visit thornburg.com. 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