Low Vol Hot Streak Could Be Cooled By Valuations

The PowerShares S&P 500 Low Volatility Portfolio (PowerShares Exchange-Traded Fund Trust II (NYSE:SPLV)) and the iShares Edge MSCI Min Vol USA ETF (iShares Trust (NYSE:USMV)) are undoubtedly two of 2016's hottest ETFs.

Investors have plunked down $6.3 billion in new money into USMV since the start of the year, a total exceeded by just six other ETFs. SPLV is not too shabby either, with year-to-date inflows of nearly $1.4 billion, a figure topped by just one other PowerShares ETF. More importantly, SPLV and USMV are up an average of 10 percent this year while the S&P 500 is up just 7.7 percent.

However, perhaps due to the perception held by some that investors take on substantial risk to generate larger returns, the idea of low volatility investing has been catching plenty of flack as well. The most frequently used criticism of low volatility ETFs is that the trade is becoming crowded, with critics alleging it is impossible for crowded trades to end well.

Let's Go, Defense

Time will tell on that front, but what could be the more pressing issue for low volatility stocks and ETFs is valuation. As in, it is getting expensive to play defensive. Obviously, some of those valuation concerns arrive by virtue of the substantial allocations to defensive sectors found in SPLV and USMV. SPLV allocates over 43 percent of its combined weight to utilities and consumer staples stocks, sectors that are traditionally richly valued. USMV's weight to those groups is a combined 23 percent, still a significant overweight compared to the S&P 500.

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Something to consider with SPLV is that its holdings are the 100 S&P 500 stocks with the lowest trailing 12-month volatility. So it is possible that if, say, technology stocks became uncommonly docile and utilities became exceptionally volatile over a given year, SPLV's rebalance would reflect those changes. Said another way, it has been documented in the past that SPLV's biggest sector weight is not always utilities.

'Style Drift'

However, adding to the case for valuation concerns, particularly with USMV, is that low volatility names are experiencing style drift into the momentum factor.

This style exposure drift in Momentum naturally would put some investors on alert for reversal risk. Interestingly, the positive bias to the IBES 1Yr forecasted revisions factor tells us that sell-side analysts are still revising their forecasts up more than down for these stocks compared with the benchmark average. This latter signal may explain why Low Vol stocks are continuing to perform in tandem with a possible crowding effect, according to an analysis of low volatility ETFs by Style Research.

The research firm cites metrics such as low earnings yield and low cash flow yield as underscoring the point that USMV is becoming expensive.

For both USMV and SPLV, the graphic portrayal of expensive valuations, coupled with high momentum, also explains why some are now very nervous about the reversal risk of Low Volatility products. The hot but expensive stocks in these ETFs may be facing a large correction, added Style Research.

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