Posted by on May 9, 2016 in Articles & Advice, Blog, Columns, Featured |

Image Credit: Christophe Vorlet

By Jason Zweig |  May 6, 2016 10:52 am ET

If you buy a “low-volatility” fund, make sure you’re comfortable paying a higher price.

That’s the warning that emerges from the surge in popularity of funds specializing in stocks that fluctuate less than the stock market as a whole.

Last month, the iShares MSCI USA Minimum Volatility exchange-traded fund took in $1.2 billion in new money. Since Dec. 31, investors have added $4.7 billion, swelling the fund’s assets by two-thirds. All told, investors have added approximately $10 billion to similar ETFs so far this year, says Dan Draper, head of Invesco PowerShares, which runs the $6.9 billion PowerShares S&P 500 Low Volatility Portfolio ETF.

No wonder, considering that the stock market crumpled by more than 10% in January and early February. The iShares and PowerShares funds have both outperformed the S&P 500 by more than 9 percentage points over the past year and have at least kept pace with it over the past three. These are young funds — launched in 2011 — but so far, so smooth.

Even so, the new investors swarming in should bear in mind that the pursuit of safety could ultimately create risks of its own.

Decades of data indicate that low-volatility stocks have outperformed the rest of the market by an average of about 1 percentage point annually at roughly 30% less risk, says Nardin Baker, an investment strategist for Guggenheim Partners Asset Management.

More return and less risk, if sustainable, should be Nirvana for investors. But for years, no one cared.

Mr. Baker began managing such portfolios nearly 30 years ago and co-wrote academic articles beginning in the 1990s describing the phenomenon. In 1991, he even created an index that tracked low-volatility stocks, although it never attracted much interest and fizzled after a few years, he says.

During bull markets, says Mr. Draper of PowerShares, investors tend to pay less for stocks that don’t make big moves. That short-term neglect is probably what has made so-called “low-vol” stocks so lucrative in the long run; if more investors had cared, these stocks wouldn’t have been cheap in the first place.

But can unpopular investments continue outperforming after they become popular?

At year end, the stocks in the iShares portfolio — among them Newmont Mining, AT&T, McDonald’s Corp. and Johnson & Johnson — traded at an average price of 22.2 times their earnings over the previous 12 months. That was almost identical to the P/E ratio of 21.8 for the U.S. stock market as a whole.

By the end of April, after all that new money had flowed in, the holdings of the iShares fund were at an average P/E of 24.3; the stock market overall was at 22.4. In four months, the fund’s portfolio shot from being only a hair more costly to nearly 10% more expensive than the market average.

It isn’t clear how much the burgeoning ETFs have themselves caused their holdings to run up in price. Many other investors follow similar strategies, and still more may buy the same stocks on different rationales. Still, the ETFs are likely among the fastest-growing of all portfolios taking a low-vol approach.

The potential for overvaluation is “a valid concern,” says Andrew Ang, a managing director and head of these investing methods at BlackRock, which manages the iShares ETF. “Excessive crowding of any strategy should send up a flag of warning.” Recent cash inflows and price increases are only two of several factors that can determine whether a strategy is getting overheated, he says.

However, such stocks were so cheap to begin with, he says, that on average they are only “slightly above the market now, not at extreme values by any standard.”

Mr. Baker of Guggenheim says the billions that have recently poured into this style of investing are only a drop in the bucket in the nearly $25 trillion U.S. stock market.

“Anybody who’s in low vol right now, they’re not going to be hurt — they’re going to be helped by the favorable tailwind as more money comes in,” he says. These stocks could outperform for many years, even decades, before they end up dangerously overvalued, says Mr. Baker, especially once you adjust for their lower risk.

Still, investors should be skeptical, says Dave Nadig, director of ETFs at FactSet: “If everybody’s chasing the same stocks, eventually they will no longer be cheap and returns will regress to the mean.”

These portfolios tend to be heavy on dividend-paying stocks in industries like electric utilities, food and beverages, and health care. Since interest rates have been falling for nearly 35 years, no one knows for sure how baskets of these stocks will fare relative to the rest of the market once rates finally rise again.

Mr. Ang urges investors not to chase the hot returns these funds have recently racked up. “I don’t think you should go into low vol to outperform the market,” he says. “You should go in to reduce your risk.”

The higher your expectations for a low-volatility portfolio, the more likely you are to be disappointed.

Source: The Wall Street Journal



Comprehensive data on stock-market volatility from 1802 through the present at Bill Schwert’s website