Markets

Michael P. Regan is a Bloomberg Gadfly columnist covering equities and financial services. He has covered stocks for Bloomberg News as a columnist and editor since 2007. He previously worked for the Associated Press.

A look at the flows into exchange-traded funds this year shows that if the stock market were an amusement park, the crowds would be lining up for the tea-cup ride instead of the roller coasters.

The iShares Edge MSCI Min Vol USA ETF ("min vol" is short for minimum volatility) has attracted more than $5.3 billion in inflows this year, the most among equity ETFs tracked by Bloomberg. That has helped to swell its market capitalization by more than 80 percent since the end of last year. The iShares Edge MSCI Min Vol EAFE ETF also promises a quieter ride with stocks in developed markets in Europe, Australia, Israel and Asia. You can see how the funds (ticker symbols USMV and EFAV) rank first and fourth among equity ETF inflows this year:

Follow the Money
ETFs that promise less volatility have been attracting large inflows this year
Source: Bloomberg
Note: Shows the five equity ETFs with the largest inflows and five with largest outflows.

Another, the PowerShares S&P 500 Low Volatility Portfolio (ticker: SPLV), has also attracted more than $1 billion in inflows to rank it in the top 15.

And that's understandable, after the one-two punch of market corrections in August and January. Both of the U.S.-focused funds performed as they were meant to, resulting in smaller declines during those two volatile stretches than the SPY fund tracking the S&P 500.  

Pain Relievers
ETFs that promise less volatility experienced smaller drawdowns during two recent market sell-offs
Source: Bloomberg
Note: Shows declines from each ETF's closing high to closing low in 2015 and from each's high in third quarter of 2015 to low in first quarter of 2016.

What's interesting is that the promise of "minimum volatility" or "low volatility" seems to be what's creating the demand, because the two funds' methodologies make them look radically different under the hood. The SPLV screens for 100 nonvolatile stocks each quarter, giving the heaviest weighting to the least volatile. The USMV tends to re-create the general shape of the market by hewing closer to the major sector weightings of the S&P 500, but keeps volatility low by picking stocks whose movements neutralize one another. 

Surprisingly, the USMV is dominated by financial firms, which make up more than 20 percent of its holdings. But it accomplishes that by avoiding all the big banks except Wells Fargo and U.S. Bancorp. Instead, it's loaded with real-estate investment trusts and insurance companies. The SPLV, on the other hand, has a heavy concentration in electric utilities and insurance companies. 

Same Goal, Different Route
Differing methodologies result in disparities in the types of stocks purchased by two low-volatility ETFs
Source: Bloomberg
Note: Shows weightings of industry groups the two have in common.

Perhaps most noteworthy, however, is that both have managed to march upward and set new highs this month even as the S&P 500 approaches the one-year anniversary since its last record. 

Standing Out
Low-volatility ETFs have managed to post decent returns in the past year as the S&P 500 has languished below its record
Source: Bloomberg

Can this outperformance last? The laws of mean reversion would suggest that it's bound to end some day. And the prospect of higher interest rates, which has caused the current spate of volatility in equities, has driven big-dividend payers like REITs and utilities to some of the worst losses in the past week. Even though insurance companies -- whose investment income stands to gain from higher interest rates -- have hung in there, the mix of stocks has been enough to cause the two low-volatility funds to underperform the S&P 500 over the past week by almost a full percentage point.

However, by design the ETFs rebalance regularly to reduce volatility. So if this volatility is here to stay for a while -- and there's a lot to suggest it could be, from questions about earnings growth and interest rates to political uncertainty -- the tea cups may still be the less stomach-churning ride to take.  

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Michael P. Regan in New York at mregan12@bloomberg.net

To contact the editor responsible for this story:
Daniel Niemi at dniemi1@bloomberg.net