SPLV: ‘Low-Volatility’ Funds Are Laden With Systemic Risk – Invesco S&P 500 Low Volatility ETF (NYSEARCA:SPLV)


Investment Thesis

Volatility is the measure of potential or actual departure from the status quo. It can be an investor’s best friend or worst nightmare- and it’s usually the latter. Humans are emotional creatures, and seeing a rapid drawdown in portfolio value is an emotional event. Emotions and investing don’t mix well and can lead to severe mistakes such as selling off a portfolio close to a market bottom.

Investors and portfolio managers want to be able to sleep at night, knowing their portfolios are safe from the tail risk that can result from volatile markets. There is plenty of institutional and retail demand for low-volatility products that can provide equity-like returns without the associated equity-like volatility and drawdowns.

For example, there is over $12 billion of assets in the Invesco S&P 500 Low Volatility ETF (NYSEARCA:SPLV), a low-volatility equity ETF. SPLV tracks the S&P 500 low volatility index, which consists of the 100 stocks from the S&P 500, with the lowest realized volatility over the past 12 months. The idea of the strategy is to reduce future realized volatility by investing in companies with lower realized volatility in the past.

But I don’t see this strategy as a particularly compelling method of avoiding future volatility in a portfolio. I believe an investment in a low volatility equity product like SPLV is a bet that the status quo will persist into the future.

If we define volatility as a measure of the chance that the status quo will not persist into the future, then investing in low-volatility strategies is just betting against future volatility. If and when volatility returns to markets, investors could be disappointed to see their “low-vol” funds exhibit wild swings in price.

Viewing Low-Vol Equity Products as “Short Vol”

When a fund picks underlying stocks with low historical realized volatility to create a portfolio, investors might expect forward volatility to remain subdued as well. The truth is, companies with low realized volatility in the past are not guaranteed to have low realized volatility into the future. This expectation of subdued volatility is an active bet against future volatility and is not so different from an explicit short volatility strategy.

Explicit short volatility became a widespread trade when investors realized that backward-looking Sharpe ratios for the strategy were exceptionally high. Explicitly short volatility strategies, such as the infamous XIV short vol exchange-traded note which imploded in 2018, at times had very high Sharpe ratios in the 3x to 6x range. Pictured below is the price and graph of a similar ETN demonstrating the high Sharpe ratios of the strategy.

Just because price volatility can be low and risk-adjusted returns can be high (at times) does not mean these products are safe. Ask any investor who had his or her capital in XIV permanently impaired during the volatility spike in 2018.

In a way, SPLV isn’t so different from explicitly short volatility strategies. Though it is not a leveraged product, an investment in SPLV is also a bet that the status quo will persist. It is an active bet that companies with low volatility in the past will continue to have low volatility in the future. While a short-volatility bet isn’t detrimental to a portfolio, investors need to be aware of precisely what they are purchasing.

The Flaw of Betting on Historically Low Vol Stocks

What causes a stock to have low realized volatility over the last twelve months? A combination of factors, but two come to mind. These factors have recently provided tailwinds for historically low volatility, but if their trends reverse, they may be the cause of price swings to the downside.

1. Leverage Fueled Buybacks and M&A

Downtrending interest rates have provided companies an avenue to borrow money to buy back stock and execute M&A. Leverage fueled financial activities can prop up share prices, thereby muting stock price volatility.

With leveraged companies, credit markets must remain open and interest rates stable for the stock to stay propped up. Leveraged companies carry more bankruptcy risk than their non-leveraged counterparts. In the event of a credit crisis, these are the companies at risk of suffering huge drawdowns and volatility in their share prices.

Companies with strong balance sheets can exhibit lower realized volatility over time. But the effects of stock buybacks and other financial activities can dampen volatility in the short term. According to David Hintz, CFA:

Risk factors-such as the effect of leverage-don’t show up in the volatility numbers over every time period. So low volatility strategies that do not include balance sheet quality factors can be susceptible to producing negative returns when interest rates rise.

In the event of rising interest rates, low volatility funds like SPLV could be vulnerable to credit crises, which would result in large stock price swings in the underlying companies. If liquidity in credit markets were to dry up, leveraged companies who used buybacks to subdue stock price volatility could suffer. Debt would be rolled over at higher rates, and profitability would be hurt. To add salt to the wound, debt-fueled stock buybacks to support a falling stock price would be off the table due to high borrowing costs.

2. Fund Inflows

Passive fund inflows subdue volatility by providing a “buyer at any price” and create a floor for stock prices. On the way up, this results in muted volatility in markets.

Conversely, fund outflows can potentially have the opposite result as inflows for a few reasons. As funds liquidate positions, it can create a “rush for the exit,” which fills stop-loss orders and the always-irrational market participants panic sell. Rapid drawdowns in price can cause active investors and speculators to step in and “buy the dip,” creating similarly violent moves to the upside.

Both of these factors have the potential to harm investors in historically low volatility stocks. Interest rates can move higher, credit markets can dry up, and passive funds can see outflows and redemptions. A reversal in these trends would result in a change in the status quo – precisely what SPLV and its ilk are betting won’t occur.

Conclusion

Low volatility strategies are popular among investors and for a good reason. People crave stability, and can they can irrationally act when volatility strikes.

I believe there are smarter ways to protect a portfolio from tail risk, including combining a portfolio of long equities with trend-following strategies and managed long volatility strategies.

While low volatility funds like SPLV look good on paper, the strategy is an implicit bet on the status quo persisting into the future. If and when a higher volatility regime overtakes markets, low volatility funds could potentially see wild drawdowns in price.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.



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