In the trailing one month through August 22, 2024, low volatility strategies have outperformed the broader U.S. equity market. This performance is evaluated using the S&P Low Volatility ETF (SPLV) since it is derived from the S&P 500 without any sector constraints and is representative of ‘pure play’ U.S. large cap low volatility exposure. In the trailing one month through August 22, 2024, SPLV was up 4.1%, outperforming the market cap weighted SPDR S&P 500 (SPY) which had a total return of 0.3% in that period. The Invesco S&P 500 Pure Growth ETF (RPG) and the Invesco S&P 500 Pure Value ETF (RPV) returned -0.1% and -1% respectively in that time frame.
Low volatility ETFs have outperformed in the U.S small cap space as well. The SPDR SSGA US Small Cap Low Volatility Index ETF(SMLV) was up 15.3% in the trailing 3 months relative to the Russell 2000 Small Cap ETF (IWM) which was up 8.8% in that same time.
This recent outperformance in low volatility marks a reversal of factor performance trends. Since the market trough of October 2022, the performance of the U.S. stock market has been driven by a small number of mega cap stocks. As a result, pure play factor ETFs that don’t use market cap weighting have significantly underperformed SPY. As seen in Table 1, SPLV, RPG and RPB have all significantly underperformed SPY over the trailing 10 years, 5 years and since the October 2022 market trough through August 22, 2024. Prior to this last month, these ETFs struggled to beat the broader market since they are relatively underweight mega cap and technology.
Strength in Defensive Sectors Driving Low Volatility Outperformance
SPLV holds the 100 stocks in the S&P 500 that have the lowest trailing 12-month volatility at the time of the quarterly rebalance. Consequently, defensive sectors like utilities and consumer staples tend to have large weights in the fund. The financial sector, although not traditionally viewed as defensive, also tends to have a large weight and is currently the largest sector in SPLV. The relative weights of these defensive sectors can vary quite significantly over time e.g. at the end of 2017, healthcare was only 6% of SPLV’s exposure but at year end 2020 it was 25%.
The sectors that are overweight relative to the S&P 500 have also been the best performers in the last three months. Financials, utilities and consumer staples are the most overweight sectors in SPLV and all three have outperformed technology over the trailing one and three months.
Looking Ahead: Rising VIX vs Likely Rate Cuts
There are two countervailing factors that are likely to determine if low volatility outperformance can be sustained. In general, a rising CBOE Volatility Index (VIX), which measures implied volatility based on S&P 500 index options, tends to favor low volatility strategy outperformance. There is a positive 0.4 correlation between SPLV daily outperformance (relative to SPY) and daily VIX returns. By contrast, there is no correlation between daily VIX returns and the outperformance of pure growth (RPG) and pure value (RPV).
As of the close on August 23, the VIX index was at 15.86, below its 10-year median of 16.16. However, it has risen in the second of this year after a very benign first half. On August 5th, 2024, the index jumped sharply to a close of 38.5, likely due to an unwind of the Yen carry trade driven by a rate increase by the Bank of Japan. The index has since normalized but could trend higher given the uncertainty around the U.S. elections and the recent uptick in conflict both in Ukraine and Israel.
A headwind for low volatility strategy outperformance is the possibility of rate cuts by the U.S. Federal Reserve in September. CFRA’s Chief Investment Strategist Sam Stovall anticipates the Fed cutting rates by 0.25% in September and then following a measured ‘slower to lower’ approach. In theory, lower rates should benefit growth-oriented sectors like technology and communication services rather than defensive sectors that are predominant in SPLV. These counterbalancing factors of rising volatility and lower rates will determine the likely performance of low volatility ETFs over the next few months.
Aniket Ullal is SVP, ETF Research and Analytics for CFRA, one of the world’s largest providers of independent investment research.
