3 reasons why low-volatility stocks may be today’s wolf in sheep’s clothing

November 15, 2016 Categories: Portfolio Corner
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3 reasons why low-volatility stocks may be today’s wolf in sheep’s clothing

Human beings like simple relationships: Complexity distracts from the message. But sometimes oversimplifying a message can be risky.

Take the field of health and diet, which I would argue is guilty of taking complex topics and presenting oversimplified heuristics as fact. For example, foods labeled as “natural” or “organic” are perceived to be healthier and safer – even though those words are meaningless unless they carry the official “USDA organic” seal. But many consumers are not aware of this nuance – and even fewer actually understand what it means for a food or product to truly qualify as “USDA organic.” It has simply become one of those branding buzzwords that sounds good and attracts demand, enabling producers to command higher prices – which in turn compels more companies to move into the crowded “organic” space, making it more difficult for consumers to distinguish the good from the bad.

I’m concerned that something similar may be happening in the investment industry.

“Low-volatility” – a branding buzzword in today’s markets?

A confluence of events has made the phrase “low-volatility” synonymous with “safety” in the minds of many investors. In many ways, the perception doesn’t come out of the blue. After all:

  • Used in the investment sense, the term “low-volatility” literally translates to “low risk/less price variation,” not protection from losing money.
  • Against a backdrop of uncertain equity markets, scores of “low-volatility” investment solutions have dominated the top performer lists for the last couple of years. Low-volatility stocks, as measured by the S&P 500 Low Volatility Index, have returned 31.2% cumulatively from January 2014 to October 2016, while the core S&P 500 Index was up 22.0% cumulatively over the same time period.
  • Investments that are considered “low-volatility” have typically tended to pay relatively high dividends, making them an attractive investment option for investors seeking income – of which there are many.

So, what’s the big deal?

The big deal is:

  1. Low-volatility stocks are currently one of the most expensive segments of the U.S. capital markets, based on valuation ratios

Because of the strong run up in prices of low-volatility stocks since 2014, they have become relatively expensive compared to the earnings they are expected to provide. For instance, as of October 31, 2016, the S&P 500 Low Volatility Index had a projected P/E ratio of 18.77 compared to a value of 16.71 for the core S&P 500 Index. The projected P/E is the ratio of current price to expected future earnings. Based on the principle of mean-reversion, this could end badly for low-volatility stocks compared to other, lower-valuation stocks, all else equal. Furthermore, an analysis of Russell Investments’ internal factor portfolios shows that on October 31, 2016 the valuation of low volatility stocks in the United States was 1 standard deviation more expensive than historically when comparing its earnings to price ratio to the S&P 500 Index.

Low volatility stocks

Indexes and/or benchmarks are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

2. Many investors equate “low-volatility” with “protection from losing money”

When investors think of the word “low risk,” they typically equate it with “protection from losing money.” While it is true that low-volatility stocks have historically tended to hold up better in a market correction than high-volatility stocks, it is not necessarily true that low-volatility stocks are a better “protection from losing money,” especially when the next two points below are taken into account. Low volatility stocks may look attractive based on the convenient brand and perceived protection from loss, but they are not immune to market downturns.

In the past three months ending October 2016, the S&P 500 Low Volatility Index not only lost money, but declined more than the core S&P 500 Index. A similar dynamic has also held true over a longer time period: The S&P 500 Low Volatility Index produced a negative monthly return in 15 of the last 36 months. In contrast, the core index was negative in only 13 of the last 36 months. In months when the core S&P 500 Index was negative, the low-volatility version of the index was more negative 15% of the time.

Total one-month return (unless otherwise indicated), in percent
Total one-month returns

3. Low-volatility might be a crowded trade

Given their recent strong returns, low-volatility stocks have become nearly indistinguishable from momentum stocks (securities that have performed well recently). As both investors seeking low-volatility investments for their traditional low-volatility merits and shorter-term investors following a classic momentum trading strategy (buying those investments whose recent performance has been strong) pile into the low-volatility trade, it risks getting crowded, which means less benefit for true low volatility investors.

Indeed, as of November 8, 2016, there were 44 ETFs tagged as “low volatility” with nearly $40 billion in assets, according to ETFdb.com. The largest low-volatility ETF, iShares Edge MSCI Min Vol USA ETF (USMV), held approximately $13 billion in AUM as of November 8th, 2016. Since the beginning of 2015, it has seen net flows of $8.7 billion. Compare that to SPY, the largest ETF tracking the S&P 500 Index, which has experienced net flows of -$28.5 billion over the same period of time ($196.5 billion total).

In the end, investors attracted to genuine low-volatility stocks may unwittingly be exposing themselves to a decidedly high-volatility experience when the tide turns – which can happen very suddenly with momentum trades. There is some evidence that the tide is already turning, with less stellar results from low volatility stocks in recent months. Since October of 2016, USMV has shed -$1 billion while SPY lost only -$556 million as of November 8, 2016.

The bottom line

“Low-volatility” might currently be the investment world’s equivalent of the “USDA organic” label and its numerous less-official derivations – a seal of approval perceived by consumers as conveying a greater degree of health and safety than products that don’t bear the special label. The risk for investors is that not all low-volatility investments are created equal, especially at a time when valuations in that segment of the market are comparatively stretched and many providers are flocking to meet consumer demand in that space.

Help your clients avoid the low-volatility wolf in sheep’s clothing by thoroughly vetting the quality of an investment opportunity that touts itself as being low-volatility and consider using downside risk and valuation ratios as additional measures of “safety.”

Disclosures:

These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the page. The information, analysis, and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity.

This material is not an offer, solicitation or recommendation to purchase any security. The securities mentioned are for illustrative purposes only.

Fund objectives, risks, charges and expenses should be carefully considered before investing.  A summary prospectus, if available, or a prospectus containing this and other important information can be obtained by visiting the website of the ETF mentioned.  Please read a prospectus carefully before investing.

Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment.

Nothing contained in this material is intended to constitute legal, tax, securities or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type.

Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns.

The general information contained in this publication should not be acted upon without obtaining specific legal, tax and investment advice from a licensed professional.

The information, analysis and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual entity.

Indexes are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

S&P 500® Index: An index, with dividends reinvested, of 500 issues representative of leading companies in the U.S. large cap securities market.

S&P 500 Low Volatility Index: measures the performance of the 100 least volatility stocks in the S&P 500 Index based on their historical volatility.

Russell Investments’ ownership is composed of a majority stake held by funds managed by TA Associates with minority stakes held by funds managed by Reverence Capital Partners and Russell Investments’ management.

Frank Russell Company is the owner of the Russell trademarks contained in this material and all trademark rights related to the Russell trademarks, which the members of the Russell Investments group of companies are permitted to use under license from Frank Russell Company. The members of the Russell Investments group of companies are not affiliated in any manner with Frank Russell Company or any entity operating under the “FTSE RUSSELL” brand.

The Russell logo is a trademark and service mark of Russell Investments.

Copyright © Russell Investments 2016. All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an “as is” basis without warranty.

Russell Investments Financial Services, LLC, member FINRA (www.finra.org), part of Russell Investments.

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