The fashion for boring stocks risks becoming a victim of its own success as money pours in

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Low volatility investment funds have been one of the year’s hottest trends. But the recent stock market ructions have underscored that they may not be the “killer app” that some investment experts think.

Low or minimum volatility exchange traded funds seek stock investments with less volatility than overall equities. They rebalance periodically to account for changes in performance. Their genesis came after academics showed how these more boring stocks actually tend to sharply outperform the stock market over time.

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“Low-vol” ETFs naturally had a receptive audience when they were first introduced in 2011. And lately they have been on a red hot streak, against a backdrop of nervousness about global growth and burgeoning interest in so-called “smart beta”, the next generation of passive investment, with ETFs focusing on one or several so-called factors, such as low-vol, cheap valuations or momentum, in an effort to outperform the wider market.

These low-vol ETFs have also benefited from the hunt for returns, as US interest rates have stayed lower for longer and European bonds offered negative yields. Many of the humdrum stocks these funds buy tend to be dividend payers.

Concerns have arisen, though, that all of the interest could be more of a curse than a blessing. Some analysts fret that their rising popularity means prices of low-volatility, high-dividend stocks have been pushed too high, and could in fact prove vulnerable to a reversal. In other words, it is simply a crowded strategy.

“It’s having its day in the sun, and it’s nothing more than that,” says Jim Tierney, a senior fund manager at AllianceBernstein. “People are overpaying for this stuff because of dividends. I completely get it, but it’s only because you get close to zero yield from bonds.”

In fact, when jitters about less stimulate central bank policy sent volatility rippling throughout the global markets last Friday, about a dozen supposedly steady, low-volatility ETFs actually fell even more steeply than the overall market, according to XTF.com data.

For example, the PowerShares S&P 500 Low Volatility ETF dived nearly 3 per cent on Friday, compared to the broader market’s 2.5 per cent decline, paring its advance this year to 7.5 per cent.

“Even though they are low volatility so much money has flown in because of the dividend yield, that now if rates go up, you are not going to have low volatility — that is the soundtrack around [low-vol funds] now,” says Nicholas Colas, chief market strategist at Convergex.

Low-vol ETFs have taken in $16bn this year with BlackRock’s USMV, the largest such fund, seeing inflows of more than $6bn. The group of 28 funds as measured by XTF.com has $44bn of assets.

Chart: Low-volatility ETFs

“Some of these low-vol stocks are low vol because they had low [price to earnings ratios], small ownership and weren’t part of big ETFs,” says Peter Tchir, head of macro strategy at Brean Capital. “I am not convinced that what made these stocks low volatility still exists now that they have been chased by all this money.”

One example is utilities. The sector of the US stock market known for high dividend yields rallied more than 20 per cent in the first half of the year. However, it is now trading at a higher price-to-earnings ratio than the overall market, and these stocks have started to weaken of late.

Chart: US utilities

Some worry about a scenario where selling in the underlying stocks creates or exacerbates redemptions for low-vol ETFs, further feeding on itself. But Rob Nestor, head of smart beta strategist at BlackRock, argues that low-vol strategies are misunderstood.

“There is a misunderstanding of how our minimum volatility strategies are constructed. They are not overweight dividend strategies per se even though a lot of people invest in dividend strategies to get low volatility,” he says.

Their funds seek to minimise volatility by buying stocks in the S&P 500 that have had relatively less volatility over the past two years and they rebalance twice a year. To limit exposure to any one sector, the funds will not overweight or underweight any sector by more or less than 5 per cent versus the weighting of the sector in the broader index.

BlackRock’s USMV now invests 8.5 per cent of its assets in utilities, less than other sectors including those it underweights versus the index for their volatility, such as technology at 15.3 per cent. “It helps to minimise, but does not eliminate rate risk,” Mr Nestor says.

BlackRock argues for long-term performance versus moves on any given day. On a rolling three-year basis, it says the fund has fallen less than the broad market in bearish times. Indeed, USMV has gained 15.4 per cent over the past 12 months, compared to the S&P 500’s 8.4 per cent rise.

Given this history of outperformance, a few bad days is unlikely to trigger any sort of shakeout from the burgeoning low-vol ETF world.

Yet with many market experts forecasting more volatility in the coming months as stocks weather a potential interest rate increase, a presidential election and another crop of earnings, these low-vol ETFs will be put to the test.

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