Utility companies feature prominently in low-vol portfolios
(Image credit: scyther5)
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.
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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."
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John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.
He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.
His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.
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