A number of large-cap banks have trickled into the low-volatility space—the basket of stocks with least price movement among peers. As low-volatility funds have seen increasing asset inflows, bank stocks should also get a boost from their growing presence in the fund group.
Bank stocks haven’t exactly been the market’s favorite over the past two years. Since the beginning of 2018, bank stocks in the S&P 500 (.SPX) have tumbled 9%, while the broader index has gained 6% during the same period. But Christopher Harvey at Wells Fargo sees multiple reasons to be optimistic about the industry.
“U.S. banks have seen significant improvement in their fundamentals, but the market has been slow in recognizing the trend,” Harvey wrote in a note this week.
Since the financial crisis, banks have been subject to stricter regulations and passed eight stress tests by the Federal Reserve. They have improved their balance sheets, kept solid credit profiles, and limited risky mergers and acquisitions. The sector has been returning more capital to investors through dividends and buybacks, and that has helped keep share prices more stable, Harvey says.
Bank stocks are less risky now than they were years ago, but still trade at a very compressed valuation, Harvey says. The group is now priced at 10 times forward earnings, much lower than the S&P 500’s 16 times.
“While many fundamental investors acknowledge that large-cap banks have been transformed, they have little faith that the group will outperform during a market slowdown,” Harvey says. “They are waiting for the cycle to play out before entering the space.”
Indeed, bank stocks remained one of the most under-owned groups among hedge fund and mutual fund managers during the first quarter, according to a recent analysis from Goldman Sachs (GS), meaning they made up a much smaller share in active managers’ portfolios compared with the benchmark indexes.
While many active managers have skipped over banks, quantitative strategies are picking them up instead, as some of these shares have joined low-volatility stocks, a group they haven’t belonged to in years.
By the end of 2016, there were no bank stocks in the Invesco S&P 500 Low Volatility ETF (SPLV). Now, they have a notable representation of 2.8% in the fund, including Wells Fargo (WFC), U.S. Bancorp (USB), and People’s United Financial (PBCT). Although that is still less than banks’ 5.6% share in the S&P 500, their representation is likely to expand.
As of April, 10 out of 19 bank stocks in the S&P 500 fell into the bottom 40% of the basket with lowest 12-month realized volatility, according to Harvey. Some potential candidates for the Invesco Low Volatility ETF in the future include JPMorgan Chase (JPM), BB&T (BBT), and M&T Bank (MTB), who have the lowest volatility among their peers.
Bank stocks should get some support thanks to their rising exposure to these low-vol strategies, which have become increasingly attractive to investors amid geopolitical uncertainties and global growth concerns. When the market environment is stressful, low-vol stocks can usually protect investors from significant downside, just like they did during last December’s selloff.
As interest rates remain around all-time lows globally, many investors are also using low-vol strategies as a substitute for their fixed-income investments, because of their bondlike characteristics, Harvey says: “It’s one of the few products that does give you diversification from your other funds.”
The iShares Edge MSCI Min Vol USA ETF (USMV) has increased its assets under management by 84% over the past year to reach $26.6 billion—the 25th largest ETF in the U.S., according to ETF Database—while the Invesco Low Volatility ETF grew 54% to $10.8 billion. Harvey told Barron’s that many of his clients have increasing exposure to low-vol strategies in their actively managed portfolios.
As low-vol gets more traction, banks’ stocks should be lifted as well, and fundamental investors will eventually follow, says Harvey.
“Eventually price will follow the fundamentals, and that is what’s beginning to happen,” he adds.
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