In the trailing month to August 22, 2024, low volatility strategies have outperformed the broader US stock market. This performance is estimated using the S&P Low Volatility ETF (SPLV) as it is derived from the S&P 500 with no sector constraints and is representative of “pure play” US low volatility exposure. In the trailing month to August 22, 2024, SPLV rose 4.1%, outperforming the market value 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, over that time frame.
Low-volatility ETFs have outperformed even the US small-cap space. The SPDR SSGA US Low Volatility Index ( SMLV ) rose 15.3% in the trailing 3 months compared to the Russell 2000 ETF ( IWM ), which rose 8.8% over the same period.
This recent good performance in low volatility marks a reversal of factor performance trends. Since the market opened in October 2022, the performance of the US stock market has been driven by a small number of mega-cap stocks. As a result, pure play factor ETFs that do not use market cap weighting have significantly underperformed the SPY. As seen in Table 1, SPLV, RPG, and RPB have significantly underperformed the SPY over the 10-year, past 5-year, and from the October 2022 market through August 22, 2024. Prior to this last month, these ETFs struggled to beat the wider market as they are relatively underweight mega cap and technology.
Strength in defensive sectors driving high low volatility performance
SPLV holds the 100 stocks in the S&P 500 that have the lowest trailing 12-month volatility at the time of quarterly rebalancing. Consequently, defensive sectors such as utilities and consumer staples tend to be heavily weighted in the fund. The financial sector, although not traditionally seen as a hedge, also tends to have a large weight and is currently the largest sector in the SPLV. The relative weights of these defense sectors can change quite significantly over time, e.g. at the end of 2017, healthcare was only 6% of SPLV's exposure, but at the end of 2020 it was 25%.
Sectors that are overweight relative to the S&P 500 have also been the best performers over the past three months. Financials, utilities and consumer staples are the most overweight sectors in the SPLV, and all three have outperformed technology over the next one and three months.
Looking ahead: VIX rise vs. potential rate cuts
There are two counterbalancing factors that are likely to determine whether the low volatility performance 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 the low volatility strategy's outperformance. There is a positive 0.4 correlation between the daily outperformance of the SPLV (relative to the SPY) and the daily returns of the VIX. In contrast, there is no relationship between daily VIX returns and pure growth (RPG) and pure value (RPV) outperformance.
At the close on August 23, the VIX index was at 15.86, below its 10-year average of 16.16. However, it has risen to second this year after a very good first half. On August 5th2024, the index jumped sharply to a close of 38.5, likely due to a softening yen trade driven by a rate hike by the Bank of Japan. The index has since normalized, but could be higher given the uncertainty surrounding the US election and the recent escalation of conflict in both Ukraine and Israel.
A downside to the low volatility strategy's outperformance is the possibility of a rate cut by the US Federal Reserve in September. CFRA chief investment strategist Sam Stovall predicts the Fed will cut rates by 0.25% in September and then follow a measured 'slow to lower' approach. In theory, lower rates should benefit growth-oriented sectors, such as technology and communications services, rather than the defensive sectors that are dominant in the SPLV. These counterbalancing factors of rising volatility and lower rates will determine the likely performance of low-volatility ETFs over the coming months.
Aniket Ullal is VP, ETF Data and Analytics for CFRA, one of the world's largest providers of independent investment research.