Growing up, I had a cockapoo dog named “Midnite” who hated the UPS man with a passion. Not even two pepper spray incidents could dilute his disdain. One day, as the UPS man was driving by the house, Midnite knocked open the front screen door and chased after him. The UPS man slammed on the brakes and Midnite ran full speed into the side of the truck, getting knocked back about 15 feet.
Like Midnite chasing the truck, investors chase the shiniest new strategies or the markets with the best returns hoping to find the Holy Grail of investing: great returns and no downside. The problem is that rather than finding Madoff-like returns without the Ponzi scheme, they run full speed into the side of a truck that knocks their account value back 15 feet. Right now, investors are chasing the USMV and XLE trucks without realizing that the brakes are about to be slammed.
One component of behavioral gravity that I watch is the fund flows of exchange traded funds (ETF). While I was reviewing the latest fund flow data, something startling jumped out at me. The fund flows into “low volatility” strategies have been epic this year. Some of these strategies promise low volatility no matter what world markets are doing, and others promise to match the performance of a benchmark without the normal level of volatility. Sounds perfect, right?
The largest of these funds is the iShares Edge MSCI Min Vol USA ETF: USMV, which attempts to mirror the return of the S&P 500 but with lower volatility. USMV has been around for five years, but almost half of its $13B in assets came in this year. This raised a red flag, and when I dug a little deeper I realized that these strategies are heavy on marketing magic and light on execution.
The stated objective of the USMV ETF is to track the results of the S&P 500 with “…lower volatility characteristics.” From a statistical perspective, the fund delivers, but barely. The annual volatility for USMV is 10.0%, versus 11.9% for SPY. It’s almost impossible to tell the difference between the monthly returns of an investment with annual volatility of 10% versus one with volatility of 12%. Not to mention you’re paying almost twice as much in management fees to invest in “low vol” as you are in SPY.
When I evaluated the returns, I realized that the USMV truck is closer than it appears. Over time frames from as short as a week to as long as five years, USMV underperforms SPY anywhere from 100 to 500 basis points. But it’s not just the overall underperformance that’s a head scratcher; it’s the timing that is most shocking.
Over the last month, SPY has declined 93 basis points while USMV has fallen 330 basis points. Over the last three months, SPY has declined 100 basis points, while USMV has declined a total of 576 basis points! Holy crap! USMV outshoots SPY on the downside, and in a huge way! Not to mention that this egregious performance discrepancy is occurring at a time of record low volatility. If a strategy’s entire premise is “low vol,” and it can’t deliver during a historic period of “low vol,” then Tina Turner and I both want to know: What is it good for?
I don’t know about you, but when I hear “low volatility,” I assume that strategy will deliver on this premise when the market is falling apart. If USMV has been careening to a slow death during a three-month stretch when SPY has barely moved, what in the world will happen if the S&P experiences a meaningful decline?!
“Low vol” isn’t the first trendy investment investors have chased hoping that they’ve found the Holy Grail, and it certainly won’t be the last. USMV isn’t the only truck that investors are chasing after with reckless abandon at precisely the wrong time.
Investors are also running full speed after the XLE truck, and are getting ready to run smack dab into the side of it because they don’t understand what is driving the returns, and that the risk is now entirely to the downside.
Energy stocks are highly correlated with the price of oil, which means that when oil goes higher, energy stocks follow. Crude has had a major counter-trend rally this year, gaining 38% so far, which is why energy has been the best-performing US equity sector by a wide margin.
Almost $2B has flowed into the Energy Select Sector SPDR ETF: XLE since January, but what is truly startling is that almost half of those inflows have come in just the last three weeks. Investors are chasing the hot performance of the energy sector even though all three gravities in my 3-G framework are flashing bearish signals for crude oil.
From a fundamental gravity perspective, the picture for crude is just as bleak as it was six months ago. OPEC members pumped a record amount of oil during September, and this doesn’t even account for the fact that Iran, Iraq and Venezuela pump about 250K barrels a day more than OPEC attributes to them.
Part of oil’s recent buoyancy is based on speculation that Russia will agree to freezing output at some level. What investors are overlooking is that even if Russia reduces its output, it’s still pumping more oil on a monthly basis than at any time since the Soviet era, when Rocky was treating Ivan Drago like a protestor in Red Square.
It’s not just foreign producers: here in the US, rig counts have increased for seven consecutive weeks. But none of these realities seem to matter, because everyone, except me, seems to think a production freeze is coming when OPEC meets on November 30.
The world is drowning in oil supply, not to mention that the weak trajectory of global economic growth will continue to drag down the demand side of the equation.
For crude oil’s quantitative gravity, I pay particular attention to its relationship with the US Dollar, which turned positive on October 6. This is important, because crude oil historically has a strong negative relationship to the greenback, meaning that typically when the USD zigs, oil zags.
Based on this alone, crude is overpriced by approximately 30%. When this relationship reverts to its historic nature, crude will go from trading in the 50’s to trading with a 30-handle. Another important aspect of crude’s quantitative gravity is that $52 a barrel remains the price equivalent of kryptonite. Crude has not been able to trade above that level since the middle of 2015, and it failed to reach $52 twice last week.
Behaviorally, it doesn’t get more bearish for oil. Hedge funds and other institutional investors are all-in on the LONG side of crude oil. Historic positioning on one side of a market almost always unwinds in a violent and unpredictable manner. I’m not sure how many buyers remain, but there can’t be many. Sentiment is so aggressively bullish on oil that when I see the current fundamental and quantitative gravities, I start to salivate and look for good entry points to be SHORT black gold.
When the correction in crude oil occurs, all those investors who chased XLE’s recent performance will realize they bought high and now must sell low. Buying high and selling low is how you wind up eating cat food in retirement.
There is no holy grail in investing. Drawdowns and losses are part of the game, and no strategy can avoid them, no matter what a fund’s marketing department would have you believe. And I can promise you that chasing the market with the hottest performance over the last three months is a recipe for disaster. So, the next time you’re tempted to invest in something that is already up 19% for the year, or in a new strategy that is sponsoring every CNBC segment, stop and think about my boy Midnite. Are you running full speed at a UPS truck?