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Low-Volatility Funds Are Making a Comeback After Struggling in the Pandemic

Investors are increasingly turning to funds that claim to protect them from major market fluctuations, even though they didn't live up to their promises during the Covid-19 pandemic.

September 23, 2022
7 minutes
minute read

Investors are increasingly turning to funds that claim to protect them from major market fluctuations, even though they didn't live up to their promises during the Covid-19 pandemic.

According to Morningstar Direct, approximately $6.5 billion has been invested in low-volatility mutual and exchange-traded funds this year. This is the first time these types of funds have seen inflows since 2019. Low-volatility funds are designed to provide a smoother market ride by holding stocks with the smallest one-day swings. This often includes shares of utilities, consumer-goods and real-estate companies that are less sensitive to economic fluctuations.

The iShares MSCI Min Vol USA ETF has seen inflows of more than $1 billion in the past month, according to FactSet. This makes it one of the most popular U.S. equity ETFs at a time when worries about more aggressive monetary tightening by the Federal Reserve are weighing on stock prices. The S&P 500 Index has fallen 5% in the past month, extending its losses for the year to 21%.

The iShares fund has seen its assets under management climb to $28 billion, though this is down from the $40 billion peak the fund reached in February 2020.

Low-volatility funds experienced rapid growth in the years following the financial crisis of 2007-2009. However, this growth came to a halt at the start of the pandemic, when the funds tumbled sharply in conjunction with the market’s broad-based selloff. This failure to provide a haven for investors has led to renewed scrutiny of these types of funds.

Even when markets began to rebound, low-volatility funds lagged behind. The stocks that led the way were in sectors like e-commerce, which are more volatile and thus less represented in low-volatility funds. Many investors were frustrated with the underperformance of these funds during both the market downturn and the rally, and so they pulled their money out.

According to Matthew Bartolini, managing director at State Street Global Advisors and head of SPDR Americas Research, low-volatility strategies can be problematic because they can lead to episodes of extreme volatility, like what was experienced in 2020. Bartolini notes that during such periods, all stocks tend to drop in value simultaneously, but that higher-risk stocks tend to recover more quickly than lower-risk stocks.

Low-volatility funds can differ widely in terms of composition and performance, so it's important to carefully examine the details of each fund before investing. Some investors warn that many low-volatility ETFs advertise similar strategies but can vary significantly in terms of how they operate.

The iShares fund from BlackRock Inc. follows an MSCI index that selects stocks based on volatility and correlation to other stocks. Further constraints, such as preventing sector weightings from straying more than 5% from that of the index, result in a fund that resembles the broader market. The iShares fund counts tech stocks such as Cisco Systems Inc. and Texas Instruments Inc. among its top holdings.

The Invesco S&P 500 Low Volatility ETF tracks the 100 stocks in the S&P 500 with the lowest variation in returns over the past year, regardless of their sector. With $11 billion in assets under management, Invesco's fund is the second largest low-volatility fund on the market.

According to Corey Hoffstein, chief investment officer of Newfound Research, low-volatility ETFs can have very different outputs. He notes that often times investors want a specific exposure, but then select a specific manager without realizing how much performance can differ. This dispersion can be 10s of percentage points.

In 2022, both the iShares and Invesco funds are outperforming the S&P 500. The iShares fund is down 15%, while the Invesco fund has fallen 11%. However, back in 2020 both funds significantly underperformed the broader market. The iShares fund returned 3.5% and the Invesco fund lost 3.6%, while the S&P 500 gained 16%.

There is no clear consensus on the outlook for low-volatility strategies among Wall Street analysts. Some believe that the current macroeconomic environment gives these types of funds more room to grow, while others question the effectiveness of selecting stocks based solely on their historical volatility.

Rob Arnott, founder and chairman of Research Affiliates, is focused on relative valuation, or whether an asset is cheap or expensive compared to the broader market.
Mr. Arnott, who is known for his innovative investment strategies like low volatility, believes that the recent rebound in the markets is no coincidence. He has stated that strategies like low volatility fell in the fourth quarter of last year to their widest discount relative to the broader market since the 2000 dot-com bubble.

According to Mr. Arnott, valuations are currently in line with historical averages, so there is no need to avoid low volatility investments. However, he warns that as more people become fearful of the market and turn to low-volatility options, the prices of these assets could become inflated.

Some analysts believe that the inflow of capital into the market may not slow down anytime soon.

According to Todd Rosenbluth, head of research at VettaFi, the strategies that are working this year are part of the reason why people are moving money. However, he expects the remainder of 2022 and into 2023 to be volatile, with the Federal Reserve continuing to raise interest rates in the fight against inflation, the war in Ukraine continuing, and election season underway.

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Adan Harris
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