The latest market rout has proved the value of low-volatility stocks.
The factor—made up of the stocks with the smallest price swings—have survived the market’s swoon in much better shape than other groups thanks to their exposure to defensive sectors like utilities and health care. The S&P 500 (.SPX) has plunged 16% since its September peak, while the Invesco S&P 500 Low Volatility ETF (SPLV) has fallen just 7%.
In fact, low-volatility stocks are doing so well that many of them have popped up in the momentum bucket made up of the market’s best performing stocks. Barron’s looked at the top 100 stocks in the S&P 500 that showed strongest 90-day price momentum as of Dec. 14, and found that 55 of them were also in basket of 100 stocks with the lowest 90-day volatility, including Coca-Cola (KO) and Dominion Energy (D). At the start of 2018, there were only 13 stocks that overlapped.
The prevalence of low-vol stocks in the high-momentum basket is historically uncommon. From 1992 to 2018, the correlation between low-vol and momentum stocks has been nearly zero, meaning the two factors don’t tend to move together over the long term, according to Feifei Li, head of investment management at Research Affiliates.
However, under certain market conditions, low-vol stocks can make up a large portion of the momentum portfolio, when what had been performing well—in this case, the fastest-growing stocks—stop working. “There is a turnover in the momentum bucket because many of these high-growth stocks are now starting to lag,” says Andrew Slimmon, managing director at Morgan Stanley Investment Management. “As it happens, low-vol—especially health-care stocks—are going into the momentum bucket.”
This might be a good sign for investors that the market is now washed out and ready to start recovering. In the midst of the financial crisis in early 2009, we saw the same thing: Over half of the top-momentum stocks in the S&P 500 were those with the lowest volatility, suggesting investors were fleeing to stability. The market started rebounding not long after that factor convergence.
Many think of factor investing as another way to divide up the market. However, unlike sectors that simply put stocks into an assigned category, it is very common to see the same stock in multiple factor portfolios if it fits the criteria. The constituents also change dynamically over time as market conditions evolve.
As a result, low-vol and momentum aren’t the only factors that have seen their relationships change. The overlap between Research Affiliates’ momentum and value portfolios nearly doubled from the second to third quarter of 2018 as the stock market switched from rally mode to extended volatility. Over the long term, value and momentum generally have a negative correlation.
Value and growth stocks, too, tend to react very differently to each other throughout the market cycle. While they typically rise together—to different extent—during a bull market, when the downturn comes, value stocks sometimes rebound while growth suffer significantly. “It’s almost like the equity and bond relationship,” explains Li, “You can’t always say they’re positively or negatively correlated. It depends on the underlying drivers.”
As for low-volatility investors, they wouldn’t have it any other way.
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