Broad Market
These are exciting times for investors and financial advisors, but the stakes are high! Sure, a bit of coin can make a difference, but let’s stay focused on the core mandate of managing risk and achieving investor goals. Volatility never feels good, but anyone not expecting it in 2024 will surely be disappointed. Buckle up! Hope to see you on Thursday (See important section in the summary).
We spend a great deal of time in the ETF Think Tank engaging with global macro traders who heighten our focus on risk. Is this important, or a waste of time after a year where the S&P 500 was up 26%? The answers lie with an investor’s timeline and risk tolerance. A 10-15% drawdown that is recouped within a one-year period will keep an investor at the craps table. However, investors in retirement who are not receiving excess to reinvest will highly avoid volatility, as the risk of a lost decade is a nightmare. This risk combined with the very comfortable 5% yield earned by “risk free” money markets makes it unsurprising they are now at an all-time high of $6 trillion. The good news is that when the correction comes around, those with the money market money will be able to seize the opportunity. Of course, all this assumes that a disciplined seller has the same skills as a buyer and is willing to catch that falling knife.
We can’t make promises, but the concern is that if we are looking to the bond market for signals, what will happen if there is stagflation, or if the risk of a recession suddenly sparks a very quick decline in interest rates? If higher-for-longer keeps investors concerned about credit spreads, and an economic contraction leads to a recession where the debt-ridden consumer is overwhelmed, how will the fed build confidence again except to lower rates, buy bonds, and accelerate the policy that continues to box a generation of investors into a bad situation? Again, this is why we see the need for alternatives. Bonds may not protect as they have in the past.
If you are paying attention, hindsight is one of the few guarantees we can offer in this business. It is ironic, therefore, that we point out the comparison between the iShares MSCI USA Min Vol Factor ETF (USMV) and the Invesco S&P 500® Low Volatility ETF (SPLV). These two ETFs share a very similar stated mandate: large cap minimum volatility and large cap low volatility. Maybe this is a case of truth in labeling. Regardless, the outcomes these past two years have been remarkably dissimilar, with USMV simply blowing away SPLV. Yes, this is a positive outcome for about 43% of the dollars allocated in the category. USMV represents about 43% of the AUM in the category and SPLV about 13%. To no surprise, 89% of the category is concentrated in the Top 10 ETFs. However, the reasons may surprise those who have not been paying attention. Note that the “minimum” volatility and outperformance in USMV has been driven by a very large allocation to technology stocks. Statistics work this way when stocks just go up and it is easy. Therefore, the question is: when things are too easy, should allocators review such a holding for purposes of a swap? Investment processes tend to revert to a mean and clearly large cap technology stock multiples are very rich. The problem with this decision is that it also assumes that interest rates will again drive utility stocks higher. However, while a swap might end up being the smart active decision to mitigate a drawdown, the other question is which business a financial advisor really thinks will work long-term, into 2025 and beyond.
Hidden Gems
In looking at minimum volatility solutions, we also thought it interesting to screen through the 9 active funds in the category, which really proved to only be 7 funds. This is an area where active management and process discipline can truly demonstrate the advantages of the ETF wrapper. To this point, active management seems to be clearly delivering from the Franklin U.S. Low Volatility ETF (FLLV). The fund has about 40% overlap to USMV and 31% to SPLV. This may change pursuant to the portfolio management team’s decision making process, which is probably the reason why the fund has performed so well recently. Currently, we would also note that this fund is 28% invested in technology, 3% more than USMV. The challenge, of course, will be managing risk when multiples inevitably contract.
Summary
Investors and their respective financial advisors need volatility to be managed. Active management can be exercised by managing a position through rebalancing, or by an active decision to swap from one strategy to another. Yes, this is an obvious statement. However, looking under the hood at a fully transparent fund, it is also nice to review how a strategy is managed. More importantly, why own something that isn’t working when you can buy the decision-making process that adapts to industry changes?
Important: This Thursday, January 18th from 9:45am to 4pm ET, we are hosting a special, all-day Spaces on X, formerly Twitter. Bring a little Bit-of-Coin, but the true excitement is that we are bringing together almost 30 different speakers. Join us to hear some truly great Global-Macro insights! Look for link details on the @ETFThinkTank.
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