Low-volatility funds are in demand, once again

Investors turn to ETFs and mutual funds that buy low-volatility stocks as a way to hedge against market volatility.

  • By Dan Weil,
  • The Wall Street Journal
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The stock market’s turmoil over the past year has sent many investors scurrying for safety. And they have been pouring money into “low-volatility” stock funds.

Experts say the strategy can make sense for investors who are willing to accept gains lower than the stock market as a whole when it is rising, in return for losses smaller than the market as a whole when it is falling. Low-volatility stocks, such as utilities and defensive consumer-goods companies, tend to underperform the market on the way up, and outperform it on the way down.

“We have used a minimum-volatility strategy for the last couple years,” says David Carter, chief investment officer at wealth management firm Lenox Wealth Advisors in New York. “It captures much of the upside and minimizes the downside. We believe this can continue, and it will likely remain a core holding for us.”

Low-volatility strategies came out of academe about 20 years ago and were quickly put to work by institutional investors, who found success, he says.

“Low-vol” mutual and exchange-traded funds started operating about eight years ago. ETFs account for the bulk of fund assets. The 57 ETFs and mutual funds with “low volatility” or “minimum volatility” in their name had assets of $101.57 billion as of Sept. 30, following a strong inflow of $31.53 billion over the previous year, according to Morningstar Direct.

This demand has come amid bouts of tumultuous trading for the overall market. The Cboe Volatility Index, an indicator of stock-market volatility, rose 35% in that year.

Low-volatility funds have lived up to their billing, providing lower returns and lower volatility than stocks as a whole, during much of the bull market that has spanned their existence.

The 57 funds tracked by Morningstar registered average annualized total returns of 9.5% for the three years ended Sept. 30 and 7.6% for five years. That compares to returns for the S&P 500 index (.SPX) of 13.4% for three years and 10.8% for five years.

The strong demand for low-volatility stocks over the past year pushed the average returns for low-vol funds ahead of the S&P 500 during that period: 6.6% to 4.3%.

Volatility for low-vol funds, as measured by standard deviation, trailed the S&P 500 for the one-year, three-year and five-year periods, according to Morningstar.

Not fully tested

The funds haven’t been tested by an extended stock-market downturn yet. But the top 25 holdings of iShares Edge MSCI Min Vol USA ETF (USMV), the biggest low-vol ETF, generated an asset-weighted return of negative 18.5% in 2008, according to Morningstar, much less severe than the S&P 500’s 37% negative return.

Low-volatility stocks are generally less cyclical and have more-stable cash flows than the market as a whole. “A company like Procter & Gamble (PG) makes consumer goods that people will buy regardless of the economy,” says Alex Bryan, director of passive strategies for Morningstar. “If you want stocks, but not all the downside risk, you get a more favorable risk-reward trade-off than the broader market.”

Low-volatility stocks are riskier than bonds but less risky than the stock market as a whole. Because of this, an argument can be made for “balanced” funds, which hold both stocks and bonds, over low-volatility funds. But annualized returns for low-volatility funds have topped those for balanced funds over the past one-, three- and five-year periods—7.6% to 5.3% for five years, according to Morningstar.

Low-volatility funds are less expensive than balanced funds, too, with an average annual expense ratio of 0.44%, compared with 0.81% for balanced funds, according to Morningstar.

While volatility for low-volatility funds is generally higher than it is for balanced funds, “low-volatility funds have tended to offer higher returns than balanced funds with comparable downside risk,” Mr. Bryan says. But there is no guarantee that outperformance will continue.

One concern for low-volatility funds is current valuations, as strong demand has pushed up prices for low-volatility stocks. The $33 billion USMV fund sported a trailing 12-month price/earnings ratio of 23.95 as of Sept. 30, compared with the S&P 500’s P/E ratio of 20.32, according to Morningstar.

“It’s widely recognized that these vehicles can be helpful in weathering uncertain times,” says Steven Violin, a portfolio manager for F.L. Putnam Investment Management Co. in Wellesley, Mass. “But valuations might not provide what investors expect. Slow growth and high valuations make me question investing in this area at the moment.”

How to choose?

For investors who want to take the plunge now or in the future, before choosing a low-volatility fund it’s important to look at its construction, experts say. You don’t want a fund that simply assembles the least volatile stocks. That would mean large bets on sectors such as real estate, utilities and defensive consumer stocks. And while those stocks are strong now, they generally trail the market in times of economic strength.

Utilities and real estate, in particular, are vulnerable to higher interest rates. That’s because companies in those sectors are heavy borrowers, and their stock yields compete with bond yields, which rise along with interest rates. Low-volatility stocks in general are more interest-rate sensitive than the rest of the market.

What you want is a fund with a manager who pays attention to each stock’s contribution to overall portfolio risk and who limits sector concentrations, experts say.

One low-volatility fund Mr. Bryan likes is the USMV fund, which limits sector weightings within 5% of the MSCI USA Index. The fund has “a well-crafted strategy that takes a holistic approach to reduce volatility and preserve diversification,” Mr. Bryan writes in a report. “It should offer a smoother ride and better risk/reward profile than the market over the long term.”

For investors who are extremely risk-averse, low-volatility funds can represent a core holding, while for those who are more adventurous, they can serve as a secondary holding.

“This is a well-established strategy that has worked in academe and real-world applications,” Mr. Carter says. “There’s a plethora of good funds out there, and expenses are reasonable.”

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