A Bunch of 'Low Volatility' Stocks Just Failed to Live up to Their Label
Calculating risk is a calculated risk.
Take low-volatility exchange-traded funds, which have gobbled up huge inflows over the past two years as investors seek exposure to U.S. stocks that won't exhibit price swings that are greater than the underlying market. However, low-volatility equity products failed that test earlier in the month when global assets sold off amid fears that central banks in advanced economies had run out of monetary ammunition.
Here's one such example that underscores the swift reversal of fortunes: A basket of large-cap U.S. stocks compiled by Credit Suisse Group AG that has had the lowest realized volatility over the past year, has also had a higher volatility than the market at large over the past month — a development that has taken root just 3 percent of the time over the last 25 years.
This pick-up in volatility occurred as investors fled these exchange-traded products holding seemingly low-volatility stocks, as the constituents parts of these ETFs all began to move in tandem and underperform the broader market.
In a research report published on Wednesday, investment analysts led by Greg Williamson at HOLT, a boutique equity valuation group within Credit Suisse, explain the magnitude of that correlation: "Since the end of the second quarter, the low volatility group has become significantly more correlated. In mid-September, low volatility stocks were 70 percent correlated to each other; a level of intra-portfolio correlation that was 30 percent higher than the market portfolio." That difference represents a 25-year high.
The strategists reckon the reason for the increasing volatility of so-called low-volatility stocks could be down to the fact they have become a crowded trade aided, in part, by the proliferation of ETFs in recent years, which allowed more investors to gain exposure to such securities at competitive fees. The explanation echoes a warning issued by Brean Capital LLC Head of Macro Peter Tchir in June, when he said that investors flooding into low-volatility ETFs likely had relatively low risk tolerance, and would be quick to dump these stocks in the event of market turmoil.
For instance, the PowerShares S&P 500 Low Volatility fund, one of the most popular ETFs of its kind, has seen more than $476 million in outflows this month, as of September 28. Williamson's team notes that the aforementioned ETF and the iShares Edge MSCI USA Minimum Volatility ETF have seen a cumulative $1 billion in outflows in the past two months, their worst such stretch in three years.
While low-volatility ETFs proved to be a source of relative safety in the two sessions in June that followed the U.K.'s vote to exit the European Union, falling far less than the S&P 500 index, they've since proceeded to lag that benchmark index by an even more sizeable margin.
Credit Suisse's team concludes that the prospect a slew of historically low-volatility U.S. large-cap stocks, have become increasingly correlated represents an opportunity for active managers to separate the wheat from the chaff, as their recent performance has likely been driven more by shifting flows than the underlying fundamentals of the respective companies.