Some funds offer to tame market’s chaos, at a price
Freaked out by the stock market’s big swings?
Then the investment industry has something it built just for you: funds that hope to offer a steadier ride. That sounds especially comforting after this year’s jarring start for markets, in which drops of more than 1 percent have become typical. But be careful, the funds carry risks.
These mutual funds and exchange-traded funds own stocks that could charitably be described as boring. Think utilities, telecoms and other companies whose profits— and thus stock prices— don’t fluctuate so much. The funds avoid jackrabbit stocks that tend to have either really good or really bad days.
These funds advertise themselves by including terms such as “low volatility” or something similar in their names, and fund companies have rolled out dozens of them in the past five years to meet strong demand.
The problem, for now at least, is that the types of stocks these funds own have uncertain outlooks. Many are at risk of falling if interest rates rise, and the expectation is for the Federal Reserve to continue raising its benchmark rate. And many have been bid up to heights that look pretty thrilling for boring companies.
“You’ve gotten to a point where they’re trading at higher valuations than a market that’s already expensive,” says Leuthold Group chief investment officer Doug Ramsey.
Six years ago, an index of the 100 least-volatile stocks in the S&P 500 was 13 per- cent cheaper than the broad index. But at the start of this year, it was the mirror image. The S&P 500 Low Volatility index was 13 percent more expensive than the S&P 500.
Many low-volatility funds focus on dividend-paying stocks, which tend to have steadier returns. The fear is that when rates rise, income investors will go back to bonds and dump dividend-paying stocks.
“Everyone is investing in stocks that look ‘low risk’ based on history,” says Jim Fallon, who runs low-volatility funds at MFS Investment Management. “That leads to a lot of crowding in this space.”
For example, Procter & Gamble has been a relatively steady stock in part because investors think people will continue buying Bounty paper towels and Pampers diapers even if the economy falls into a recession. But that has made it popular— maybe too popular. Its shares are trading at nearly 30 times their earnings per share, close to the highest level in 13 years. The S&P 500 trades at 16 times earnings.
That’s why Fallon is considering stocks that rival low-volatility funds may not be. For example, many funds invest in only the 10 or 20 percent of stocks that have had the mildest price swings in the S&P 500 or another index over a certain time period. At his MFS Low Volatility Equity fund, Fallon considers any stock as long as it’s in the bottom 60 percent of the 1,000 largest U.S. stocks in terms of volatility.
The biggest catch in low-volatility investing, Fallon says, lies in the time commitment. “You can’t put it in and pull it out if you’re disappointed after a year.”