Sex Appeal of Low Volatility Funds Continues, But Beware

2012 has been the year for low-volatility strategies, an area that has dominated product development lately, especially on the ETF side. AQR Capital Management just launched three defensive equity mutual funds this week, designed to “provide equity-like returns with lower volatility and smaller drawdowns,” the firm said. Who doesn’t want lower volatility, right?

Sure, investing in stocks or sectors with the lowest amount of market volatility sounds good. Such funds promise equity exposure in a world of low interest rates, with fewer sleepless nights.

Low-volatility ETFs, specifically, are rapidly growing in popularity. As of July 9, these funds have a total of $3.2 billion in assets, according to Morningstar. The biggest fund is the PowerShares S&P 500 Low Volatility ETF (SPLV), with over $2 billion. In the past six months alone, these funds have gathered $1.9 billion, Morningstar says.

In my mind, however, a red flag always goes up when sexy, new investment strategies become en vogue.

A few months ago, I talked to a few people about the growth of low-volatility ETFs, who said concerns about these strategies may be warranted. Christian Magoon, CEO of Magoon Capital, an asset management consulting firm, says such strategies use a look-back methodology, in that they try to invest going forward by investing in areas that have been more stable in recent months.

“My concern on this is that a lot of times products are designed looking backward and by the time they get out, they really are designed for market conditions that have happened over the previous few years and they end up selling well because people have that memory over the last few years and believe they’re buying the antidote to what’s happened,” Magoon said. “But oftentimes markets change quite a bit, and a reversal in the way markets work would probably limit the upside potential of a lot of investors.

“The saying goes, ‘A lot of people like to shut the barn door after the horse has already gotten out.’ When you look at inflows typically, you tend to see them chase performance and a lot of times the top performing asset class or strategy in the past, going forward tends to be not the best bet for investors.

“Once you start playing with volatility, you’re starting to get a little more into a directional call in the markets because, depending on low or high volatility, you’re making a call on a bull or a bear. Granted you’re still in equities, but you’re tilting one way or the other.”

In a research note, Eric Weigel, director of research at Leuthold Group, said low volatility strategies are incredibly defensive and massively underperform in up equity markets. These strategies are not optimal as standalone equity strategies unless one has a very bearish view of equity markets, Weigel said.

“The only way to control volatility during a market crisis is to actively reduce market exposure when it happens," said Lee Munson, founder and CIO of asset management firm Portfolio LLC, in Albuquerque, N.M. Munson also recently published his first book: Rigged Money: Beating Wall Street at its Own Game.

“Nobody would be talking about them if they didn’t do well in backtesting."

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