By John Spence & Tom Lydon
The long-term outperformance of low-volatility stocks flies in the face of modern portfolio theory; nonetheless this market "glitch" has been well-documented by academic studies. Yet the 2008 financial crisis and its lasting psychological impact on investors probably have more to do with the soaring popularity of low-volatility ETFs than any research being churned out by the Ivory Tower.
"The market crash of 2007-09 scared scores of investors out of the stock market. Many are still out, and a lot of those tiptoeing back in are wary of volatility," writes the former executive director of Dow Jones Indexes, John Prestbo, for MarketWatch. "So, ETFs promising less fluctuation now have an eager clientele that previously didn't exist, or was much smaller."
However, he argues that low-volatility funds shouldn't be considered stand-ins for diversified, total-market ETFs because they hold fewer stocks and take different sector bets.
For example, PowerShares S&P 500 Low Volatility Portfolio (NYSEARCA:SPLV) has 24.4% in consumer discretionary and 30.9% in utilities, two traditionally defensive sectors. The general outperformance of defensive sectors over cyclical sectors so far in 2013 has provided a tailwind for the fund.
"This rally has been largely defensive-led," said Mark Newton, chief technical analyst at Greywolf Execution, in a recent WSJ.com MarketBeat report.
SPLV is the largest and oldest low-volatility ETF with about $4.3 billion in assets under management.
A rival, iShares MSCI USA Minimum Volatility (NYSEARCA:USMV), is actually the best-selling ETF in the category so far this year, raking in about $1.4 billion. USMV takes a slightly different approach from SPLV in that the tracking index tries to stay more diversified from a sector perspective.
"On balance, these two low-volatility portfolios offer what they advertise, which is less volatility than the broad market. Whether they are good investment choices is another matter entirely," Prestbo writes.
"Mainly, at this point these funds shouldn't be relied upon to turn those academic results into real money," the index guru added. "Like growth and value funds, they appear to alternate their times to shine. When an investor decides to get in and get out will greatly affect his realized returns."
USMV and SPLV, the low-volatility ETFs, both outperformed the S&P 500 by a slight margin in the first quarter. But what seems to draw skittish investors to these funds is the promise of a smoother ride with lower volatility, or price swings - not superior performance.
As Prestbo points out, depending on the market, low-volatility stocks may or may not outperform in any given year. Investors in low-volatility ETFs should also keep track of so-called risk-adjusted returns that factor in volatility.
"The evidence behind low-volatility investing is truly impressive. However, low-volatility strategies can underperform during bull markets," says Morningstar ETF analyst Samuel Lee.
iShares MSCI USA Minimum Volatility
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.