2 Popular Minimum Volatility ETF Strategies

Tuesday, August 21st, 2012

by Del Stafford, iShares

By now, you’ve probably heard about the benefits of a minimum volatility (or, “min vol”) strategy and the ETFs that seek to deliver it, but you might still be wondering how to use these funds in a portfolio. One common misconception is that min vol ETFs are a tool designed for volatile markets specifically, but this simply isn’t the case. In fact, the two minimum volatility ETF strategies we see our clients using most often are both strategic, long-term plays that have nothing to do with current market volatility. These two strategies are: 1) lowering overall portfolio risk or 2) increasing allocation to equities without increasing overall portfolio risk.

Lower overall portfolio risk
Investors who are trying lower their overall portfolio risk can simply replace their existing market capitalization based equity investment with the corresponding minimum volatility ETF. For example, let’s say a client’s portfolio consists of 60% equity and 40% fixed income. Let’s use the MSCI USA Index to represent “equity” and the Barclays US Aggregate Bond Index to represent “fixed income”. The client would replace the 60% allocation to the MSCI USA Index with a 60% allocation to the MSCI USA Minimum Volatility Index.

This strategy would result in a ~20% reduction in portfolio risk since inception of the analysis (June 2008) and an even greater reduction in risk in the nearer term (see below).

Increase allocation to equities without increasing overall portfolio risk
Like the example above, an investor looking to employ this strategy would start by replacing their existing market capitalization based equity investment with the corresponding minimum volatility ETF, but then they would also increase their allocation to the minimum volatility ETF while decreasing their allocation to fixed income. After replacing the MSCI USA Index with the MSCI USA Minimum Volatility Index, the investor would increase their allocation to the MSCI USA Minimum Volatility Index and decrease their allocation to the Barclays US Agg Bond Index until the total portfolio risk reaches the level they desire. For example, they may seek a level of portfolio risk that is just below the since inception risk of the Original Portfolio, which is 12.15%.

This strategy allows the investor to increase their allocation to equity by 17% while obtaining a consistently lower level of risk than the Original Portfolio (see below).

While there are certainly other ways to employ minimum volatility ETFs in a portfolio, our team has found that these two strategies are the most commonly used among our clients.

Source: Markov Processes International (MPI)

Del Stafford, CFA is the iShares Head of Product & Investment Consulting and a regular contributor to the iShares Blog. You can find more of his posts here.

The iShares Minimum Volatility Funds may experience more than minimum volatility as there is no guarantee that the underlying index’s strategy of seeking to lower volatility will be successful.

Copyright © iShares

Tags: Barclays, Bond Index, Case In Fact, Common Misconception, Current Market, Equity Investment, ETF, ETFs, Fixed Income, Inception, Investor, Investors, Ishares, Market Capitalization, Market Volatility, Msci, Portfolio Risk, Risk 2, Usa Index, Volatile Markets, Volatility Index
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Stepping Off the Sidelines with Fixed Income ETFs (Tucker)

Sunday, November 20th, 2011

by Matt Tucker, iShares

A few weeks ago, my colleague Russ blogged about the preference skittish investors are showing for cash. Given the volatile market conditions and uncertain political environment, it’s understandable that investors are finding comfort in cash.

But Russ gave three reasons why moving to cash might be a mistake, and he said it is worth considering keeping some equity exposure. I agree with Russ that staying on the sidelines could be a mistake, and I would emphasize that for investors looking to reduce portfolio risk there are a number of fixed income ETF solutions available.

For investors who crave the comfort of cash, short duration vehicles could be a good way to dip your toes into the fixed income market. Here are three reasons why:

1. No long-term commitment

Fixed income ETFs trade throughout the day on a stock exchange, giving you flexibility and the ability to nimbly adjust your exposure. Say, for instance, you become concerned about risk. You can sell a risky asset class and access a fixed income ETF intra-day. If the market changes, you can then sell the ETF and re-deploy your proceeds.

2. Potential for higher yields than money market funds

iMoneynet reports that the 30-day average yield on money market funds as of November 8 is 2 basis points. Investors who do not seek a stable net asset value and who are looking for higher yields may find fixed income ETFs to be an interesting option. For investors who want to keep interest rate risk low, but who are comfortable taking on some credit risk, the iShares Floating Rate Note Fund (FLOT) offers investors a 30-day SEC yield of 1.45% as of November 10 with a duration (a measure of interest rate sensitivity) of only 0.14 years. For investors comfortable taking on a low level of both interest rate and credit risk, the iShares Barclays 1-3 Year Credit Bond Fund (CSJ) has a 30-day SEC yield of 1.42% as of November 10 with a duration of 1.85 years. There are also lower risk options like the iShares Barclays Short Treasury Bond Fund (SHV) that has a 30-day SEC yield of 0.04% as of November 10 but that invests solely in US Treasury securities. Past performance does not guarantee future results. For standardized fund performance, please click on the following tickers: FLOT, CSJ, SHV.

The key is that an investor has the control to select exactly the exposures they want, and, by extension, avoid the exposures they don’t want.

3. Less volatile than longer-term funds if interest rates rise rapidly

Short-duration investments will have lower interest rate sensitivity than longer-term funds. For example, the 0.12 year duration of FLOT means that we can generally expect FLOT’s price to decline by 0.12% if interest rates rise by 1%. By comparison the iBoxx $ Investment Grade Corporate Bond Fund (LQD) has a duration of 7.51, meaning that we could generally expect its price to decline 7.51% if interest rates rose by 1%.  (Potential iShares solutions: FLOT, SHY, or CSJ)

The bottom line is that investors who are looking for yields above those provided by money market funds have a range of options to choose from. Just keep in mind that yield isn’t free — it always comes along with some type of extra risk. By understanding what risks you are willing to take and constructing a short duration portfolio appropriately, an investor can design a wide range of potentially higher yielding alternatives to traditional cash vehicles.

Disclosure: Author is long FLOT and SHV

Source: Bloomberg

The performance quoted represents past performance and does not guarantee future results. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when sold or redeemed, may be worth more or less than the original cost. Current performance may be lower or higher than the performance quoted. Performance data current to the most recent month end may be obtained by calling toll-free 1-800-iShares (1-800-474-2737) or by visiting www.iShares.com.

An investment in fixed income funds is not equivalent to and involves risks not associated with an investment in cash or money market funds.

For differences on mutual funds and ETFs, please click here.

Buying and selling shares of iShares Funds will result in brokerage commissions.

Bonds and bond funds will decrease in value as interest rates rise. Securities with floating or variable interest rates may decline in value if their coupon rates do not keep pace with comparable market interest rates. Narrowly focused investments typically exhibit higher volatility and are subject to greater geographic or asset class risk. The Funds may be subject to credit risk, which refers to the possibility that the debt issuers will not be able to make principal and interest payments. The iShares Floating Rate Note Fund’s income may decline when interest rates fall because most of the debt instruments held by the Fund will have floating or variable rates. An investment in the Funds is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency.

Tags: asset class, Asset Value, Basis Points, Bond Fund, Credit Risk, Csj, Equity Exposure, Fixed Income Market, Interest Rate Risk, Interest Rate Sensitivity, Ishares, Market Changes, Matt Tucker, Money Market Funds, Net Asset, Political Environment, Portfolio Risk, Risky Asset, Skittish Investors, Term Commitment, volatile market conditions
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Don’t Play Monopoly with your Portfolio

Thursday, November 10th, 2011

This Week’s Feature: BMO Equal Weight Utilities ETF ( Ticker: ZUT )

Globally equity markets staged an incredible recovery from their October lows. However, Europe’s ongoing troubles ensure that heightened anxiety will remain. Even more reason to keep a careful eye on risk inside your portfolio.

Major equity indices for the United States, Europe and Emerging Markets rallied by 14% to 20% over the last five weeks. The S&P TSX 60 rose 12.5%. Commodities rallied too, with crude oil and copper up about 19%.

Euro-zone relief drove the rally, just as Euro-zone despair drove the drop. Until the Euro-zone begins to resolve its debt issues, every move it makes will agitate markets. When the Greeks decided to put their debt plan before a referendum last Tuesday, European equity markets fell 5%.

In this volatile environment, investors must be more vigilant in managing portfolio risk. One risk often overlooked is counterparty risk. As the exchange-traded market has developed, more, er…esoteric, ETFs have arisen, some of them with counterparty risk.

First, I should stress that most ETFs invest directly in stocks or bonds. These plain vanilla ETFs pose no counterparty risk. Other ETFs use futures contracts: no counterparty risk here either, but they do have other issues such as leverage that I have discussed before.

Then, there are ETFs that use “over-the-counter” (OTC) derivatives contracts. These are the ones that come with counterparty risk. These ETFs do not invest directly. Instead, they pay a fee to a counterparty, say a bank, and in exchange, the bank pays the ETF the return on some index like the S&P 500. All goes well until the day the bank is unable to pay the return.

How can you tell whether your ETFs have counterparty risk? You must read the prospectus. In a past role as a manager of OTC derivatives for a Bay Street fund manager, I was responsible for controlling counterparty risk. Are most investors ready or willing to do that? Unlikely.

In Europe, institutional investors are selling their OTC ETFs in droves and shifting to plain vanilla ones. France’s second largest bank, Société Générale, has seen outflows of Euro 4.4 billion this year from the OTC ETFs managed by its Lyxor division. There is nothing inherently wrong with the ETFs but investors are worried about SocGen’s exposure to Greek debt. SocGen’s stock price has fallen nearly 60% this year.

In recent notes, I discussed sector diversification and lower-risk, higher-dividend sectors like REITs. Another is the utilities sector.

When we play Monopoly, my sons tend to pass on Water Works and Electric Company in favor of Pacific Ave or Boardwalk. Like them, most Canadians pass on utilities for their portfolios.

That’s largely because the S&P TSX Composite passes on utilities. Three sectors dominate the Composite – financials, energy and materials – with nearly 80% of the weight. Utilities account for just 2%, even though their benefits would seem to mesh well with what most investors want.

Utilities are less volatile than energy, materials and even the Index as a whole. They pay better dividends than the Index and every other sector barring telecoms. Best of all, they are not so closely tied to the events in Europe.

There are a couple of Canadian utilities ETFs available: the iShares S&P TSX Capped Utilities (XUT/TSX) and the BMO Equal Weight Utilities (ZUT/TSX). Of the two, BMO ZUT is larger with about $95 million in assets.

iShares XUT is market cap weighted and holds 11 companies, with Fortis, TransAlta, Emera, Canadian Utilities and Atco making up about 70%. XUT pays a dividend of about 2.9%.

BMO ZUT is rebalanced twice a year to equal weights across 15 companies. It pays a dividend of about 5.3%. ZUT also holds one oil pipeline company, Pembina: not strictly a utility but the same idea.

The high yield will attract longer-term investors. In the near term, keep in mind that valuations are rich. The average price-to-earnings ratio for the companies inside ZUT is 23.4 times, with a price-to-book of about 1.93 times. For the Composite, the values are 15.2 times and 1.84 times.

Some of the premium is justified by the benefits. But a price fall in the near term is possible and that would be a good time to enter.

ZUT is less volatile than XIU, the TSX 60 ETF.

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Tags: Bonds, Canadian, Careful Eye, Commodities, Crude Oil, Debt Issues, Debt Plan, Emerging Markets, Equal Weight, Euro Zone, European Equity, Futures Contracts, Greeks, Last Tuesday, Lows, Otc Derivatives, Outlook, Plain Vanilla, Play Monopoly, Portfolio Risk, Prospectus, TSX 60, Volatile Environment, Zut
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How to Deal With Excessive Risk Concentration?

Tuesday, June 14th, 2011

Tags: Advisory Firm, Aggregate Risk, Asset Managers, Blow Up, Canada Article, Canadian, Canadian Market, Excessive Risk, Forethought, Fund Risk, Infrastructure, Investment Manager, Investment Managers, Investment Portfolios, Optimal Approach, Pension Fund Manager, Portfolio Risk, Private Markets, Risk Exposure, Risk Reduction, Risk Reports, Single Company, Trigger Points
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Is Private Equity Riskier than Public Equity?

Monday, May 23rd, 2011

Is Private Equity Riskier than Public Equity?

by Leo Kolivakis, Pension Pulse

Jonathan Jacob of Forethought Risk, an independent risk advisory firm, sent me a recent blog posting, Private Equity – Riskier than Public Equity?:

Is private equity riskier than public equity?

What if it exhibits lower volatility? Is that lower volatility real or based on some measure of appraisal bias?

My tendency is to believe that there is a measure of appraisal bias which dampens the volatility of private equity – how many business valuation experts would mark down a private equity portfolio by 60% when the broad stock market drops by 50%? Conversely, would they mark up private equity by more than the market’s positive performance?

Two heavyweights showdown on this issue – CPP vs OMERS

CPP, on page 28 of their 2011 annual report, demonstrate how they manage portfolio risk with a private equity deal. In order to purchase $100 worth of private equity, CPP sells $130 of public equity then purchases $30 of fixed income and $100 of private equity. In their opinion, the $30 of fixed income is there “to adjust for the higher risk of embedded leverage in a private equity asset”.

OMERS disagrees. In their 2010 report OMERS states “the more predictable and sustainable performance of private market assets will underpin total Fund returns during times of depressed returns in the public markets”. (p 11)

Personally, I am not a huge subscriber to the efficient market hypothesis – I believe there are opportunities in the markets that can be exploited by those with superior ability in this field. However, I do believe that the idea of private markets as a saviour of pension funds due to its lower exhibited volatility is based on an illusion – that of an appraisal bias in the mark-to-market of those investments. If we valued these assets based on what a 3rd party would pay, that would be more reflective of reality.

I asked a senior pension fund manager to weigh in on this discussion. Here is what he shared with me:

It’s cumulative IRR that is the measure that counts. Full stop. Net of currency. Any other measure is misleading or irrelevant.

Also, the only public comp worth anything is a takeover bid that succeeds. If the stock market drops 50 percent, the enterprise value of any specific listed business may well be unchanged.

Have you noticed most takeovers occur at large premiums to the market? Should PE mark to the stock market, and then add a 20 to 50 percent enterprise value premium? That would actually make some sense. The public market bias is hard to shake.

I told him that there is a private market bias too, just look at the LinkedIn IPO. He responded: “LinkedIn is not worth $9 billion, that’s the market cap based on the small issue that floated.”

I’ll tell you from personal experience that nothing pisses off the public market people at pension funds more than the bogus benchmarks and big bonuses that private market investment managers get. One portfolio manager still gets visibly agitated with me when discussing this topic: “It’s such bullshit! Would love to see these private market pension managers try to consistently beat the S&P 500. All they do is fly around the world and write big checks to big funds. And they have the gall to call this alpha!?!?”

The private equity pension fund managers respond by stating that public market managers are terrible at beating their benchmarks, so it’s best to exploit opportunities in private markets where there is more information asymmetry. Moreover, they claim that the skill set in private equity is in demand and harder to find so they should be paid more than their public market counterparts.

I think pension fund managers should focus on delivering alpha wherever they can find it. Look, my views on private market benchmarks are simply based on economic theory. They should reflect the leverage, beta, and liquidity risk of the underlying portfolio, which is why I prefer a spread over some public market benchmark (even if it’s not perfect because of lag adjustments). I also agree with Jonathan analysis above, the way CPPIB allocates risk between public and private markets reflects these risks (albeit they really complicate things to the nth degree! The KISS principle should apply here too.)

But that senior pension fund manager I quoted above is right. At the end of the day what counts is cumulative IRR net of currency. Everything else is irrelevant. Whether a pension fund invests or co-invests in direct PE investments to save on fees, or through fund investments, at the end of the day cumulative IRR net of currency and fees is what counts!

I have worked in private equity and spoken to a few reputable fund managers. Guys like David Bonderman at Texas Pacific Group (TPG) aren’t a dime a dozen (never met him but met other big PE managers). And even he got into some bad deals in the past. I want you to take a close look at the Canada Pension Plan Investment Board’s fund partners in private markets. A lot of these funds are the cream of the crop in private markets. Doesn’t mean they’re infallible, but they have added significant value added over the years and will likely continue to do so. Unlike public markets, there is much stronger evidence of performance persistence in private markets.

Finally, I agree with Jonathan, private markets are not the “saviour” that pension funds make them out to be. Appraisal values smooth volatility and senior pension fund managers often will mark private market assets down in bad years to mark them up when the recovery comes. This helps them collect the big bonus based on 4 year rolling returns. I’ve seen this so many times that it’s become standard practice among the large pension funds.

But I’m also seeing a lot of outright manipulation in public markets. Big hedge funds and big bank prop desks engaging in naked short selling via multi million dollar high-frequency platforms. At one point, pension funds get fed up and say “screw public markets”, we’re going to move all our assets into private markets and have more control over them. Obviously they can’t move everything into private markets and there is a symbiotic relationship between public and private markets, but the shenanigans in our corrupt public markets are part of the impetus behind the institutional shift of assets into private markets.

Copyright © Pension Pulse

Tags: Advisory Firm, Business Valuation, Canadian Market, Cpp, Efficient Market Hypothesis, Forethought, Heavyweights, Market Assets, Omers, Pension Fund Manager, Pension Funds, Portfolio Risk, Private Equity Deal, Private Equity Portfolio, Private Market, Private Markets, Public Equity, Public Markets, Sustainable Performance, Valuation Experts, Volatility
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