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The "Outlook" on Low Volatility Funds

04/24/2019 5:00 am EST

Focus: FUNDS

Todd Rosenbluth

Senior Director of ETF & Mutual Fund Research, CFRA Research

As the U.S. stock market sold off in the fourth quarter of 2018, lower volatility smart-beta ETFs gathered approximately $7 billion of net inflows, providing investors with a more defensive approach of staying invested in equities, notes CFRA Research analyst Todd Rosenbluth in The Outlook.

Yet, even as the S&P 500 bounced back and had one of its best opening quarters in years, these low-vol products pulled in the same amount of new money.

To CFRA, this is a sign that investors are not fully optimistic the bull market will continue in 2019. Yet, the most popular of these smart beta ETFs are not exposed to historically defensive sectors equally.

CFRA has a year-end 2019 forecast for the S&P 500 of 2,940, which is modestly higher from current levels, but also reflects our view that this first quarter price gain of 13% will not be erased.

However, some investors are concerned that an earnings and/or economic recession could send the market lower. According to Sam Stovall, Chief Investment Strategist at CFRA, consumer staples and health care stocks held up best during bear markets since WWII.

Not surprisingly, Stovall likes to say: “When the going gets tough, the tough go eating, smoking and drinking — and if they overdo it, they have to go to the doctor.” But he reminds us that “holding up” is not synonymous with “advancing,” as defensive groups tend to lose less than others during market declines.

They don’t typically rise in price. In the first quarter of 2019, the $25 billion iShares Edge MSCI Minimum Volatility ETF (USMV) gathered $3.5 billion, in line with the cash haul the smart-beta ETF pulled in the final three months of 2018.

Of the two ETFs highlighted here, USMV is more-sector neutral approach in its downside protection efforts. The MSCI index-based fund uses an optimization approach to build a minimum variance portfolio and has sector constraints that limit the over/under weighting relative to the broader equity market. The ETF is rebalanced semi-annually.

As of early April, USMV had 15% of assets in the health care sector, second most to the Information Technology sector (17%), while Utilities (8%) was the eighth largest sector. CFRA Hold recommended Pfizer (PFE) was the largest of the health care stocks in the portfolio.

Meanwhile, $10 billion Invesco S&P 500 Low Volatility ETF (SPLV) gathered $1.1 billion in the first quarter of 2019, up from approximately $860 million in fourth quarter of 2018. SPLV tracks an index of S&P 500 constituents that have the lowest volatility; the ETF is rebalanced quarterly.

Due in part to SPLV’s lack of sector bands, the Utilities (25% of assets) sector is the largest, followed by Real Estate (18%). Surprisingly, Information Technology (7%) was slightly larger than the historically defensive Health Care sector (6%).

Among utilities, CFRA Strong Buy-recommended Exelon (EXC) was the largest position. Both ETFs garner S&P’s top overall rating of Overweight due to our view of their holdings, low expense ratios, tight bid/ask spreads and more.

Although an ETF’s three-year track is not the driver of our rating methodology as it is others, USMV’s 12.2% three-year annualized total return as of April 4, ahead of SPLV’s 11.4% gain, highlights why an understanding of their underlying exposure matters. Wall Street expects a near 2% decline in Q1 S&P 500 earnings.

Many forecast this is the first step to an earnings recession. CFRA, however, thinks it will simply be a short-term stumble along the way. CFRA’s view is also that the economy will sidestep recession, and we therefore have searched for unanticipated opportunities.

Subscribe to CFRA Research's The Outlook here…

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