Schaeffer's Trading Floor Blog

Is It Time to Ditch Low-Volatility Names?

The relationship between bonds and this low-volatility ETF

by 6/3/2014 7:53 AM
Stocks quoted in this article:

In a world of low volatility, one would expect a fund comprised of low-volatility stocks to have performed well. And in 2014, that has been the case for the most part.

But is that about to end? This from Brendan Conway in Barron's:

Steady-Eddie investors, it's time to review your favorite exchange-traded fund strategy: "low volatility." As of mid-2014, the idea of owning the market's most stable stocks, and only those stocks, has worked, even excelled. Investors have enjoyed a smoother ride than the S&P 500 and have beaten the index to boot. Now for the bad news: The factors behind this outperformance aren't sustainable.

One secret to the strategy's strong year is the bullish tone in the bond market, which, these days, is like a performance-enhancing drug for the most stable stocks. A rise in bonds tends to buoy the prices of equities that behave like bonds, such as the dividend payers populating low-volatility ETFs. The trend has been especially helpful for shares of utilities. As the most bond-like corner of the stock market, utilities now lead the S&P 500, and make up 25% of the most popular low-volatility ETF, the $4 billion PowerShares S&P 500 Low Volatility Portfolio (SPLV). But turnarounds happen. In 2013, amid a bond selloff and rising interest rates, this fund fell by 3.5% in May and 4.9% in August, both worse than the broad index. Utilities have already given back some of their 2014 gains.

Just to review, the SPLV is an index of the 100 S&P 500 stocks with the lowest realized volatility over the previous 12 months. It rebalances quarterly, and is generally a good proxy for the "Steady Eddie" strategy highlighted above.

It has, indeed, done quite well so far in 2014 (click chart to enlarge).

Daily Chart of SPLV since January 2014
Chart courtesy of TD Ameritrade

And it has outperformed the SPDR S&P 500 ETF Trust (SPY) as a whole.

Daily Chart of SPLV vs SPY since January 2014
Chart courtesy of TD Ameritrade

That, of course, makes sense in light of the bond action this year, if you subscribe to the correlation theorized above. And it's pretty consistent with the February-April flight out of momentum. Even the most volatile of S&P 500 stocks aren't exactly dominated by high flyers, but they're still high-beta on a relative basis. So, it figures that SPY underperformed for a few months before that whole trend petered out in May.

The underperformance issue with these low-volatility pups does seem to crop up a couple of times every year, but generally speaking, it's not a bad thing. With small-cap/momentum/high-beta getting slammed earlier this year, one of two things had to happen: either more stable, big-cap names would follow, or the high-beta would stop getting pounded. But in both cases, low volatility stood to underperform. Fortunately (if you're net long or bullish), it seems to have resolved with stabilization in small-caps/high-beta. SPLV is clearly still acting well; it's only lagging on a relative basis.

Now, if bonds weaken, it does make sense that this underperformance will get worse. But again, that sounds like a good thing. It implies the economy is doing better, which suggests that growth names will take the baton again. And that, generally speaking, leads to a better rally.

Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.

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