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.”