By holding stocks with the smallest one-day shifts, low-volatility funds offer a more comfortable market experience
Even though they didn't perform exactly as promised during the height of the Covid-19 pandemic, investors are swarming to funds that boast about their ability to protect investors from significant market swings.
Citing figures from Morningstar Direct, the Wall Street Journal reported that about US$6.5 billion has poured into low-volatility mutual and exchange-traded funds this year, putting the products on pace for their first annual inflows since 2019.
By investing in stocks with the smallest one-day swings, higher or lower, low-volatility funds promise a more comfortable market experience.
Read more: Why it's time to revisit low-volatility strategies
Shares of utilities, consumer goods, and real estate companies frequently benefit from this bias because they are less susceptible to economic highs and lows.
Data from FactSet Research shows the largest low-volatility fund, the iShares MSCI Min Vol USA ETF, has amassed more than US$1 billion in assets over the past month. Concerns over a more aggressive Federal Reserve tightening of monetary policy have driven those inflows, which place the fund among the most popular U.S. equity ETFs. The S&P has lost 21% of its value this year, thanks in part to its recent 5% decline.
In the years that followed the financial crisis of 2007–2009, low-volatility funds sprang up and expanded rapidly. But the start of the pandemic saw an end to that trend; the funds fell precipitously along with the market's widespread selloff, casting doubt on their effectiveness as havens for investors.
Low-volatility funds didn't participate even when the markets started their frantic rebound. That was led by stocks in industries like e-commerce, which are typically less represented in low-volatility funds and more subject to market swings.
Many investors abandoned low-volatility strategies in frustration over their underperformance during both the market downturn and rally.
Read more: Why building a lower-volatility equity portfolio has only got harder
Another problem with low-volatility ETFs is that even though many of them promote similar strategies, they can differ significantly in composition and performance, making it essential to look at the underlying elements.
“Low-volatility ETFs can end up with very different outputs,” Corey Hoffstein, chief investment officer of Newfound Research, told the Journal. “Oftentimes investors want a specific exposure, but then select a specific manager without realizing how much performance can differ—and that dispersion can be tens of percentage points.”
There appears to be no consensus on Wall Street about the prospects for low-volatility strategies.
Some claim that the macroeconomic environment's unpredictability gives those funds more flexibility. Detractors, meanwhile, don’t see the value of choosing stocks based only on their historical volatility.
Still, inflows may not stop anytime soon, according to some strategists.
“These strategies are working this year, and that is part of why people are moving money,” said Todd Rosenbluth, head of research at VettaFi. “But it is a fair expectation that the remainder of 2022, and into 2023, is going to remain volatile. The Federal Reserve is still raising interest rates in the ongoing global battle against inflation, the war in Ukraine continues, and election season is upon us.”
