Performance Is Trumping Safety in the Low-Volatility ETF Craze

This year's hottest ETF trend is all about hot money.

Kuroda’s Secretary Says ‘Play Hard’ As BOJ’s Soccer Team Attacks

A soccer ball is seen as members of the Bank of Japan (BOJ) soccer club rest during half time of Japan's interbank soccer league match against Resona Bank Ltd.

Photographer: Kiyoshi Ota/Bloomberg

The low volatility exchange-traded fund (ETF) craze has little to do with investors seeking less volatility.

Instead, the billions of dollars flowing into ETFs that track stocks exhibiting the least amount of volatility is a classic case of performance-chasing. Like little kids playing soccer, many investors follow the outperformance ball, so to speak, wherever it goes. It happens with stocks, bonds, active mutual funds, hedge funds, and increasingly with ETFs. Right now, the soccer ball is in the low-volatility part of the field, where nearly all low-vol ETFs are outperforming their respective markets—be they large-caps, small-caps, or international equities.

The performance-chasing can be seen clearly in the flows for the iShares Edge MSCI Min Vol EAFE ETF (EFAV). EFAV saw a steady drip of money before this year from investors legitimately looking for a smoother ride. Flows that come in drip-style tend to indicate thoughtful asset allocation money.

But then, the slow drip turned into a flash flood as the ETF's outperformance of its parent index began to take off. Flows that come in flood-style usually suggest hot money looking for a quick buck.

Source: Bloomberg

This deluge of inflows has turned low-volatility ETFs into the fastest-growing smart-beta category ever. Such ETFs have collectively taken in $13 billion this year— twice as much as currency-hedged ETFs, the last big performance-chasing craze, took in during their first six months.

Perhaps the most unbelievable statistic surrounding the low-volatility ETF mania is that 32 of the 34 products on the market have seen inflows. Even for a soccer ball situation such as this, it is unusual for the money to run that deep into products; typically the flows hit only five to 10 "favored" ETFs.

This helps explain why everyone and their mother is launching smart-beta ETFs. When the strategy hits a home run, to mix our sports metaphors, there is money to be made for everyone—or almost everyone. The two low-volatility ETFs that haven't seen inflows this year are the iShares Edge MSCI Min Vol Global Currency Hedged ETF (HACV) and the Guggenheim U.S. Large Cap Optimized Volatility ETF (OVLC).

So how will this all end? Most likely in the same way it has always ended—with underperformance and a lot of "I told you so" from investors who may or may not be jealous that they missed such a stonking rally.

At some point, the soccer ball will inevitably leave low-volatility land and get kicked into another part of the investment field, most likely an area that has been neglected for years. For instance, currency-hedged ETFs had a good, two-year run of outperformance, collecting some $24 billion in the process. The trade inevitably stopped working, with $10 billion of outflows recorded so far this year.

The same fate awaits low-vol ETFs, For now, let the good times—and the soccer ball—roll.

Eric Balchunas is a senior ETF analyst for Bloomberg Intelligence. This piece was edited by Bloomberg News. More ETF research can be found on terminal at BI ETF <GO>

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