Low-volatility stocks are the market's Superman. Can they defy kryptonite forever?

  • By Daren Fonda,
  • Barron's
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If the market has a Clark Kent these days, it’s low-volatility stocks: Beneath their dull facade lies a superhero defying mortal pressures.

Leuthold’s director of research and equities, Scott Opsal, made that comparison in a post on Friday. He argued that while low-volatility stocks are richly valued, they’re benefiting from strong investor momentum, falling interest rates, and investors’ ongoing demand for safety.

“It’s a scary trade because of the valuation,” Opsal told Barron’s. “But people today want to own stocks because bonds are uninteresting, so they’re buying the chicken bets, which are low-volatility stocks.”

By definition, these are humdrum stocks: Their volatility is below-average compared to the broader market, individual sectors, or other stocks within a sector. Utilities, real-estate investment trusts (REITs), and insurance companies make up about 50% of the S&P 500 Low-Volatility Index, but there are other methodologies that result in different sector and industry weightings.

Utilities, REITs, and insurance are mature industries with modest growth and respectable yields, Opsal wrote: “No glamour stocks here; these are companies that rarely produce big surprise and are therefore less stressful to own in down markets.”

Yet the S&P 500 low-volatility index has been surprisingly strong as the market has risen. Over the past 12 months, the S&P 500 (.SPX) produced a 3.2% return, Opsal points out. But the S&P low-vol index returned 14.7%. That beat the return of other “factors,” such as quality (up 4.7%), momentum (4%), and value (1.9%). Low-volatility stocks also beat the S&P 500 Dividend Aristocrats—stocks with a long history of dividend growth—which rose 6.2% over past 12 months through Aug. 6.

Valuations, however, have climbed along with the stock prices. Low-volatility stocks are trading at almost three standard deviations above the mean, according to Opsal. That means low-vol is more expensive than it has been nearly 99% of the time, relative to the mean, since 1990.

But low-volatility has consistently been expensive over the last few years. And investors who avoided the stocks due to rich valuations have missed out on strong returns.

That may still be the case. The sectors dominating the S&P 500 low-vol index “are geared to win in a falling-rate environment,” Opsal said. They have a negative correlation to interest rates; as rates fall, the sectors rise more than usual. “If global rates continue their race to the bottom,” Opsal wrote, “these boring yield plays will receive more love from income-seeking investors.”

Investors will also want safety if the market really takes a dive. Volatility has picked up lately as stocks have teetered around trade issues and concerns about slowing economic growth. More signs of a slowdown could easily knock the market off its perch.

“Low-vol stocks are fully priced,” Opsal said, “but they offer two things that people want today: yield and safety if things go into the dumper.” While valuations look stretched, he added, “I didn’t put a sell on low-vol because it has too many things going for it.”

Investors can gain exposure to the factor through ETFs. The Invesco S&P 500 Low Volatility ETF (SPLV) tracks low-vol stocks in the S&P 500. Other options include the SPDR SSGA US Large Cap Low Volatility Index ETF (LGLV) and the iShares Edge MSCI Min Vol USA ETF (USMV).

The iShares ETF is the largest in the space with $32 billion in assets. It also has one of the lowest expense ratios at 0.15%.

Bear in mind that these ETFs holds stocks across multiple sectors, screening for volatility, correlations, and other factors. If the market really takes a dive, the ETFs may lose less than the market average. But they will still go down in price, since even Superman has his kryptonite.

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