I’ve always been skeptical about low-volatility funds, which attempt to provide stock-like returns but with less pronounced ups and downs along the way.  Low-volatility is one of many so-called investing “factors” that have been identified through analyses of historical stock market data.

But because low-volatility funds have only existed since about 2011, I’ve never felt like there was a sufficient track record to fully evaluate them.  Perhaps more importantly, from 2011 through 2019, stocks enjoyed an unremitting bull market with relatively muted volatility by historical standards.  In other words, low-volatility funds have only been tested in one type of market regime.

That all changed in early 2020 when the decade-long bull market was abruptly ended by a -34% drop in stock prices, as measured by the S&P 500.  To the surprise of many observers, the market quickly recovered.   Nonetheless, the 2020 market feels distinctly different from the previous decade-long bull market, in no small part because of the continuing economic impacts from the pandemic.

And the current volatility levels support the idea that the 2020 market is different.  From the start of 2012 through the end of 2019 the CBOE volatility index (or VIX) was never above 30, and it usually resided somewhere in the low teens or single digits, indicating persistently low volatility.  But in late March of this year, the VIX spiked above 65 and still hasn’t fallen below the high 20s with any consistency.  The higher stock market volatility of 2020 marks the kind of conditions that should favor low-volatility funds.

So, I thought it would be fun to see how some of the more popular low-volatility funds have been performing recently.  But first, I should describe low-volatility funds a bit more.

What Are Low-Volatility Funds?

Low-volatility index funds are designed for investors who want better returns than “safe” bonds but with less “risk” than a typical stock index fund, with risk being measured by routine volatility.  As the name implies, a low-volatility index fund is designed for less volatility than broader index funds (like the S&P 500).  But due to the lower implied risk,  low-volatility index funds are also expected to generate annual returns that are a few percent less than a broader index fund.  So, low-volatility funds are billed as offering better “risk-adjusted” returns, but not better absolute returns.  You’ll also often see the claim that low-volatility funds should experience less downside volatility when the broader market declines.

Low-volatility funds use an array of indexing rules.  SPLV is one of the most popular low-volatility exchange-traded funds (ETF), and it simply picks out the 100 lowest volatility companies from the S&P 500.  Because stocks from the same industries often make similar price movements, almost 50% of SPLV’s stocks currently come from the healthcare and consumer non-cyclical sectors, as this pie chart from ETF.com shows.

USMV is another popular low-volatility index ETF.  But it uses more complex indexing rules to pick a basket of large-cap stocks that, in aggregate, are expected to have lower volatility than broader index funds.  USMV’s rules include evaluating correlations between stocks to generate lower aggregate volatility, which also tends to decrease sector concentration, as this pie chart from ETF.com shows.

Perhaps more importantly, these two charts highlight that different indexing rules for “low-volatility” can generate substantially different combinations of stocks.

What’s The Appeal of Low-Volatility?

Low-volatility funds have grown in popularity over the last decade.  As of mid-2019, low volatility exchange-traded funds (ETFs) accounted for more than 10% of all U.S. stock ETF inflows and reached over $28 billion in new investments through the end of last year.  Looking globally, the average low-volatility ETF price at the start of 2020 was about 20% more expensive than its most comparable broad index ETF.  These data indicate a huge demand for index funds that claim to smooth out the normally bumpy ride involved with stock investing.

However, to a mindful investor, smoothing the ride is unimportant.  That’s because, for a long-term stock investor, routine volatility is a poor measure of the true risk of stock investing, which is the risk of a permanent loss.  Mindful investors understand that counterproductive behaviors, like panic selling during market volatility, are a product of emotional responses to temporary market gyrations.  Mindful practices and other techniques can help minimize our emotional responses to routine volatility.

But to many people, it likely feels easier to instead find a financial tool that might help to pacify their emotional reactions.  And the financial industry is all too happy to oblige, as long as you’re willing to pay more for that pacifier.  Even though the managers of SPLV have only one simple rule to follow, they charge an annual expense equal to 0.25% of the money invested.  Compare that to VOO (a popular S&P 500 index fund) that has an expense ratio of only 0.03%.  A fraction of a percent in additional cost doesn’t sound like much, but that means SPLV costs 8 times as much as VOO!  To me, that’s like car shopping and paying 8 times the normal sticker price because the car has a soothing color.

2020 Performance of Low-Volatility

But perhaps I’m jumping the gun.  Let’s see how low-volatility funds performed during the spike in volatility this year.  Here’s a chart from Portfolio Visualizer comparing the performance of the two low-volatility funds I described above to a low-cost S&P 500 index fund for year-to-date 2020.  SPLV is the blue line “Portfolio 1”, USMV is the red line “Portfolio 2”, and VOO (S&P 500 index fund) is the gold line “Portfolio 3”.

As expected, VOO (gold line) produced better absolute returns to date.  But the difference in the percent returns through September would be pretty startling to anyone expecting a “slightly lower” return from their low-volatility fund:

• SPLV (blue line): -6.5%
• USMV (red line): -1.3%
• VOO (gold line): +5.5%.

And how well did the low-volatility funds manage that downside risk?  At the end of the March crash, the percent return for the funds was:

• SPLV (blue line): -19.0%
• USMV (red line): -17.2%
• VOO (gold line): -19.6%

It’s been anything but a smooth ride for low-volatility investors this year.  And those low-volatility fans who were calm enough to hold on past April were rewarded with continued losses, even while the S&P 500 index fund climbed back to a decent +5.5% return.

Long-Term Performance of Low-Volatility

Looking at only one timeframe can be misleading.  So, let’s look at the entire history of these funds going back to the start of 2012.  Here’s the graph for that period.  Same funds, colors, and portfolio numbers.

Again, the S&P 500 fund, VOO (gold line), generated higher absolute returns to date.  Notably, the two low-volatility funds (blue and red lines) sometimes outperformed VOO, with the period around 2016 being the best example.  But when the real volatility finally showed up in early 2020, the low-volatility fund returns fell to lower lows than VOO.  And unlike VOO, they still haven’t recovered to their previous highs.

Here are some key statistics on these funds if you had held them from January 2012 through the end of September 2020.

Fund	Annualized Return (CAGR)	Volatility (St. Dev.)	Risk-Adjusted Return (Return/Risk Ratio)	Worst Year	Maximum Drawdown
SPLV (low-vol.)	11.3%	11.0%	1.0%	-6.5%	-21.4%
USMV (low-vol.)	12.8%	10.4%	1.2%	-1.3%	-19.1%
VOO (S&P 500)	14.2%	13.0%	1.1%	-4.5%	-19.6%

In my view, the low-volatility funds provided no tangible benefits as compared to investing in a simple S&P 500 index fund.  The vaunted “risk-adjusted” return that is supposed to pacify our emotions was virtually identical across the three funds.  The worst years and maximum drawdowns were all roughly the same too.  The SPLV fund in particular performed poorly exactly where it’s supposed to offer an advantage.  SPLV’s risk-adjusted return, worst year, and maximum drawdown performance were all worse than the S&P 500 index fund!

Focusing instead on the better-performing USMV fund doesn’t really boost the case for low-volatility ETFs.  Would anyone feel relatively pacified by a -19.1% maximum drawdown as compared to -19.6% drawdown for VOO?  And who would want to trade USMV’s measly 0.1% advantage in risk-adjusted return, when it means losing 1.4% in absolute annualized return as compared to VOO?

What’s Wrong with Low-Volatility?

A key premise behind low volatility funds seems to be that volatility patterns in the market are “persistent”.  This graphic from S&P Dow Jones Indices shows that stocks with lower volatility in one year usually had lower volatility in the next year as indicated by the blue highlighting.  That is, low volatility was “generally” persistent.

But there’s a substantial variance in these data.  For example, about two-thirds of the stocks in the first quintile stayed in that quintile the next year, but a full one-third moved.  And the same is true of the fifth quintile.  Based on the performance history of SPLV and USMV we just saw, a two-thirds level of persistence doesn’t seem like enough.

And this graph of SPLV’s sector allocations from Morningstar shows the substantial long-term drift in the stocks that are least volatile over time.

When these variations happen suddenly, it can substantially impact low-volatility fund performance in particular years.  For example, in early 2020, SPLV found itself tilted heavily toward typical low-volatility sectors like utilities (27.4% of the fund), real estate stocks (15.2%), and financials (15%).  But these were some of the sectors worst hit by the March spike in unemployment, which created doubts about people’s ability to pay utility bills and rent.  And the Fed’s zeroing of interest rates hurt most major financial institutions.  So, 2020 is proof that “generally” persistent low-volatility is meaningfully different from “always” persistent.

Conclusions

Perhaps it’s no surprise that in the second quarter of 2020 the SPLV fund saw a net outflow of $1.2 billion in investments.  And while USMV had a net inflow of $0.15 billion in the same period, that was a trickle as compared to the $14 billion of inflows it garnered throughout 2019.  Clearly, the “smooth ride” from low-volatility funds doesn’t stop investors from panic selling in a downturn.

And if that’s true, what’s the point of low-volatility funds?  A lot of the time, the smooth ride turns out to be pretty darn bumpy.  And those bumps can occur exactly when they’re least expected.  So, investors looking for safe havens can be shocked out of the market just when it has the greatest potential to permanently damage their portfolios.

I’d go a step further and say that low-volatility funds are downright dangerous.  These funds are essentially luring investors who have the greatest fear of market gyrations, which means they likely have the least ability to tolerate those gyrations.  Once lulled into false complacency, the hapless investors learn the difference between the pet theory of persistently low-volatility and the wild, real-life version that can easily inflict a vicious bite.  The mindful verdict is that low-volatility funds are a particularly nasty kind of fake news.