Low volatility – or low rates?

Tracker funds investing in “boring” stocks have done well in the past 25 years – but is that set to change?

921_MW_P16_strategy
Utility companies feature prominently in low-vol portfolios

One big winner from the post-financial crisis environment has been "low volatility" ("low-vol") exchange-traded funds (ETFs). The idea behind these ETFs (part of a range of "smart beta" ETFs that invest in indices with specific themes or theories backing them) is that they are full of equities that are less volatile (ie they suffer fewer ups and downs) than the wider stock market. As a result, they should give investors a smoother ride overall the highs might not be as high, but nor will the lows be as severe and as frightening. And so far it seems they have largely done their job.

But can this continue? There's an interesting piece on the CFA Institute's Enterprising Investor blog by Nicolas Rabener of FactorResearch on the topic. Rabener notes that low-vol ETFs have done very well in recent decades. In fact, rather than deliver a smooth but unexciting path through the market, they have in fact beaten it on many occasions. If you had bought the least-volatile 10% of US stocks in 1991 (and carried on rebalancing into the least volatile tenth on a monthly basis), then you'd have thrashed the market. Rabener also found that, looking at Japanese and European markets, your maximum drawdown (in other words, the biggest hit your portfolio would have had) was significantly smaller than the equivalent for the wider markets. So not only did the low-vol portfolios beat the market, they also saved investors a lot of nailbiting in the process.

There's just one problem. The sectors that dominate in low-vol portfolios accounting for more than half of the value of the stocks in these indices during the period under examination are property and utility companies. Why is that important? Utility and property companies appeal to investors for one main reason they tend to offer higher yields than most other sectors. A world of ultra-low and falling interest rates (which is the environment we'd seen right up until at least mid-2016), made these investments extra attractive to yield-hungry investors.

However, it also means that these stocks are unusually sensitive to movements in interest rates and in both directions. If rates start to rise again as we're seeing now then these sectors are likely to suffer (just as bond prices fall when yields rise, so the price of "bond proxies", such as these stocks, tend to fall as interest rates rise). After all, why invest in commercial property if a Treasury bond yields just as much? So if, as Rabener puts it, "declining interest rates likely explain most of the low-volatility strategy's attractive risk-adjusted returns" then the end of the long bond bull market could spell the end of that. Indeed, "if interest rates rise, then low volatility ETFs could become toxic."

Recommended

When ETFs can’t work miracles
Analysis

When ETFs can’t work miracles

Bond ETFs can be cheap and liquid, but tracking high-yield debt is more difficult than tracking stocks.
20 Jan 2020
The MoneyWeek Podcast: How the Law Debenture Corporation's unusual structure gives it an edge
Investment trusts

The MoneyWeek Podcast: How the Law Debenture Corporation's unusual structure gives it an edge

Merryn talks to Dennis Jackson and James Henderson of the Law Debenture Corporation about what makes the trust unique, the regulatory tailwinds it can…
27 Oct 2020
Being unpopular can make life easier for companies – just ask BP and HSBC
Investment strategy

Being unpopular can make life easier for companies – just ask BP and HSBC

When you're as hated as banking and the oil sector, it doesn't take much to pull off a nice surprise. John Stepek explains what that means for investo…
27 Oct 2020
Nine of the best new investment trusts and ETFs
Funds

Nine of the best new investment trusts and ETFs

A lot of appealing investment trusts trusts and exchange-traded funds have emerged now that the market has calmed down. David Stevenson picks nine of …
26 Oct 2020

Most Popular

The Bank of England should create a "Bitpound" digital currency and take the world by storm
Bitcoin

The Bank of England should create a "Bitpound" digital currency and take the world by storm

The Bank of England could win the race to create a respectable digital currency if it moves quickly, says Matthew Lynn.
18 Oct 2020
Don’t miss this bus: take a bet on National Express
Trading

Don’t miss this bus: take a bet on National Express

Bus operator National Express is cheap, robust and ideally placed to ride the recovery. Matthew Partridge explains how traders can play it.
19 Oct 2020
Three stocks that can cope with Covid-19
Share tips

Three stocks that can cope with Covid-19

Professional investor Zehrid Osmani of the Martin Currie Global Portfolio Trust, picks three stocks that he thinks should be able to weather the coron…
12 Oct 2020