Tutorials

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

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.

Subscribe to MoneyWeek

Become a smarter, better informed investor with MoneyWeek.

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."

Advertisement

Recommended

Visit/504054/the-power-of-mean-reversion
Funds

The power of mean reversion

When it comes to investing in funds, don’t chase the top performers – look for the cheapest ones.
1 Apr 2019
Visit/503809/investing-in-funds-the-most-important-number-to-look-at-before-you-buy
Funds

The most important number to look at before you buy any fund

Many investors get distracted by past performance when they buy a fund. But there’s something else to consider that will have a much bigger influence …
22 Mar 2019
Visit/financial-glossary
Investment strategy

Financial glossary

A guide to many of the terms used in the world of investments and finance. Click on individual headings for a detailed explanation of each term.
15 Jan 2020
Visit/520115/investment-trusts-the-cinderella-of-investment-arrives-at-the-ball
Funds

Investment trusts: the Cinderella of investment arrives at the ball

Investors should look beyond the market noise of a single year and examine the bigger picture. Max King explains what we can learn from 25 years of in…
8 Jan 2020

Most Popular

Visit/520525/currency-corner-how-high-can-the-pound-go-against-the-euro-in-2020
Currencies

Currency Corner: how high can the pound go against the euro in 2020?

In the month in which we should finally leave the European Union, Dominic Frisby takes a look at the pound vs the euro and asks just how high sterling…
13 Jan 2020
Visit/520575/20-predictions-for-the-2020s
Investments

Where will markets be in 2030? Here are 20 forecasts for the 2020s

A lot has changed in the last ten years – stockmarkets soared, technology transformed our lives and politics has changed beyond measure. Here, Dominic…
14 Jan 2020
Visit/520338/how-much-the-state-pension-will-rise-by-this-year
Personal finance

How much the state pension will rise by this year

While Boris Johnson promised to hold a full budget within 100 days of his election victory, many of the details of next year’s state pension increases…
10 Jan 2020
Visit/520553/money-minute-wednesday-15-january
Economy

Money Minute Wednesday 15 January: UK inflation and house prices

In today’s Money Minute, we look ahead to the latest UK inflation and house price figures, plus we have Germany’s GDP data for 2019.
15 Jan 2020