By Dan Weil
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 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 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."
Mr. Weil is a writer in West Palm Beach, Fla. He can be reached
at reports@wsj.com.
(END) Dow Jones Newswires
November 03, 2019 22:21 ET (03:21 GMT)
Copyright (c) 2019 Dow Jones & Company, Inc.
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