There were many losers in October's stock market selloff. Low-volatility stocks, however, have emerged as something close to winners.
The S&P 500 (.SPX) tumbled 6.9% in October, its worst month since 2011. But the Invesco S&P 500 Low Volatility exchange-traded fund (SPLV), which counts Coca-Cola (KO) and Procter & Gamble (PG) among its largest positions, dropped just 3.1% last month. That's less than half the downside suffered by the broader market.
It's exactly what low-volatility stocks are supposed to do. But that wasn't how the strategy of buying the market's least-volatile equities had been working earlier this year. We blamed rising interest rates for that, and October's economic worries had the opposite effect—it lowered bond yields and helped lift defensive sectors. As a result, the S&P 500 Utilities Sector (.GSPU) index rose 1.9% last month, while the S&P 500 Consumer Staples Sector index (.GSPS) gained 2.1%. Coca-Cola and Procter & Gamble both rose in October and, like these, helped limit the low-vol losses.
There has always been something strange about buying the low-vol stocks. Contrary to the widely accepted notion that higher risks bring higher returns, academic research has shown that not only do low-vol stocks offer a smoother ride, but they can also generate higher returns over long periods. If you are concerned about more bumps for the rest of the year, low-vol might still be a good bet.
The only problem: They are kind of expensive. Stocks in the S&P 500 Low Volatility index have been trading at a higher price/earnings ratio than the broader market, and the gap is still widening. Simulation data from Research Affiliates show that low-vol strategies are currently priced well above their historical average since 1968.
That's ironic, given that the concept of low-vol outperformance started with the assumption that people tend to chase higher-risk stocks in the hope of catching a "lottery ticket," making those stocks overpriced relative to their actual businesses. As low-vol stocks become more popular, however, they might inevitably fall into the same trap and lose their value advantage.
Still, critics have been complaining about low-vol valuations for a while now, and it hasn't done much to affect their performance. In fact, low-vol stocks persistently underperformed the market in the late 1990s, when they were cheap, and have tracked the S&P 500 closely since 2008, despite their relatively high valuations.
Instead, the popularity of the strategy might have more to do with periods of out- and underperformance than valuation. Invesco's Michael Fraikin argues that low-vol strategies still only makes up a fraction of the whole investing world, and assets under management devoted to the strategy are still well below more-traditional factors such as value, momentum, and high dividend. "At this stage, although they may have stretched, valuations have not deviated hugely from historic norms," Fraikin explains.
Indeed, valuation isn't a problem as long as devotees still believe in the strategy. The danger of appears, however, when the price starts to drop and everyone suddenly wants to exit en masse. Amazon.com (AMZN), is a good example of a stock that keeps going up despite a nosebleed-level valuation. "There's always going to be a time when things become too extreme," explains Omar Aguilar, chief investment officer for equities at Charles Schwab, "The last one who got in will suffer the most."
But when it comes to low volatility, we're not there yet.
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