Riding the Wave of Low-Volatility Funds

Generally, the phrase “low volatility” isn’t one to be associated with “all the rage.” Nonetheless, that’s exactly what low-volatility mutual funds and exchange-traded funds are this year, as investors flock to safety in this low-yield, low-growth environment.

“The appeal is obvious,” says Dave Nadig, director of ETFs for FactSet Research Systems in Pittsfield, Massachusetts. “These are the least-risky stocks. You are getting participation in the stock market’s upside and mitigating downside risk.”

Low-volatility mutual funds and ETFs drew a net inflow of $15.1 billion for the first seven months of the year, according to data Morningstar assembled for Institutional Investor. Analysts say the funds can represent sensible long-term holdings in a diversified portfolio, though they caution that fund valuations are elevated, thanks to the recent buying wave.

The funds are designed to give investors a smoother ride than that with the overall stock market. They tend to outperform when the market falls and to underperform when it rises. That makes them attractive for risk-averse investors. “You’re giving up performance in strong markets in exchange for getting protection in a downturn,” says Alex Bryan, director of passive strategies research for Morningstar in Chicago. “Over a full market cycle, low-volatility funds should give you a better risk-adjusted performance.”

Stocks that make up low-volatility funds tend to be blue chips that pay dividends, such as defensive consumer companies and utilities. So they’re generally what are called quality companies, says Karim Ahamed, a partner at wealth management firm HPM Partners in Chicago.

Whereas Bryan says investors shouldn’t expect the funds to outperform the broader stock market over the long term, in the short term they’ve done exactly that. Low-volatility funds generated a total return of 8.01 percent in the first seven months of 2016, compared with 7.66 percent for the Standard & Poor’s 500, according to Morningstar. Low-volatility funds trailed the index for one-, three-, five- and ten-year periods.

But some analysts point to broader data that do indicate long-term outperformance for low-volatility stocks. Ahamed cites data showing that the MSCI World Minimum-Volatility index outperforms the MSCI World index over the long term. From 1975 through 2014, the minimum-volatility index outperformed the world index in 46 percent of one-year rolling periods; 52 percent of three-year periods, 55 percent of five-year periods, 65 percent of ten-year periods and 91 percent of 25-year periods.

One area in which there’s no debate is volatility. The low-volatility funds tracked by Morningstar had an average volatility lower than the S&P 500, as shown by standard deviation, for the one-year, three-year and five-year periods. The S&P was less volatile for the ten-year period, but most low-volatility funds have been around for five years or less.

This year’s strong performance by low-volatility funds has come as investors seek safety from financial turmoil around the world. In addition, they are looking for dividends at a time of record-low bond yields.

Since 1967, low-volatility stocks have traded on average at a discount to their book value that is 25 percent greater than the discount for capital-weighted indexes, including the S&P 500, says Feifei Li, head of investment management at Research Affiliates in Newport Beach, California. As the demand for low-volatility funds has pushed valuations higher, that advantage has disappeared. “That’s a risk people must take into account” when deciding whether to purchase low-volatility funds now, she says.

Morningstar’s Bryan isn’t worried about a big slide for these funds any time soon. Although valuations matter, a lot of strategies have high turnover to make sure they minimize volatility. “The biggest risk is a strong market rally in which these stocks won’t keep pace,” he says.

He acknowledges a concern shared by other analysts that low-volatility funds have overweighted utilities, real estate investment trusts and a few other sectors, which might not keep pace going forward. Nonetheless, “there isn’t risk of a crash,” Bryan says.

Eric Balchunas, ETF analyst at Bloomberg Intelligence in Philadelphia, notes that the funds’ blue-chip status confers some stability. “If you’re holding AT&T and Procter & Gamble, how far can you go down?”

Still, Li says investors in low-volatility stocks should be careful to make sure that they aren’t too concentrated in terms of countries, industries and stocks with liquidity issues. Trading volume is small for some low-volatility stocks, because they don’t excite investors.

The two biggest low-volatility funds in the U.S. — both ETFs — take differing approaches, Balchunas notes. The $14.9 billion iShares Edge MSCI Minimum-Volatility USA ETF looks at multiple sectors and tries to choose stocks within them that together keep volatility down. Meanwhile, the $7.7 billion PowerShares S&P 500 Low Volatility ETF simply holds the 100 least-volatile stocks in the S&P 500. That of course leaves it open to sector concentration.

“If you’re an older investor that wants more chill, you probably want the iShares fund. The PowerShares is more tactical,” Balchunas says.

Get more on exchange-traded funds.