Opinion: Why the ‘Fed Sell’ Makes Low-Volatility Stocks an Attractive Replacement for Bonds

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Time to give up low volatility investment strategies? These strategies favor stocks whose bottom line returns are the least volatile. Not only does the low volatility of these stocks persist, on average, they have also historically earned more than the market itself. Higher return with lower risk is a winning combination. But not last year. The Invesco S&P 500 Low Volatility ETF SPLV, + 1.17%, for example, lost 1.4%, in contrast to a total return gain of 18.4% for the SPDR S&P 500 ETF SPY, + 1.44%. That negative alpha of more than 20 percentage points is more than double the next worst year for this ETF.

This year has not been kinder to the low volatility strategy. In the first quarter, the Invesco ETF had a negative alpha of 2.5 percentage points. In fact, as you can see in the graph below, SPLV’s three-year tracking alpha has been hovering near the zero line for close to 15 years.

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For advice on the place of low volatility in the current market environment, I turned to Nardin Baker, Chief Strategist at South Street Investment Advisers. Baker co-authored (with the late Robert Haugen) some of the first academic studies documenting the historical performance of low-volatility stocks. Perhaps the best-known of these studies – Low-risk stocks outperform all observable markets in the world – showed that the low-volatility effect existed in each of 33 equity markets in different countries during the period between 1990. and 2011. Tell me what you thought last year was nothing more than an exception to the impressive long-term rule. But it did not. In an interview, Baker said that both the US economy and stock market have fundamentally changed in ways that greatly reduce the future attractiveness of low-volatility stocks. Baker attributes this change directly to the Federal Reserve’s easy money policy. Because of that policy, investors face less risk in pursuing aggressive strategies than they would otherwise. They are confident that “when the market turns risky, the Fed will step in to save the day and prop up the market,” he said. This policy is known colloquially on Wall Street as the “Fed Proposal.” As I wrote last fall in a column on research by a Duke University professor, there is strong evidence that such a position exists. Because of the Fed’s proposal, Baker reasoned, low volatility strategies have become noticeably less compelling. “When you eliminate the downside risk of a security, you are basically telling investors that their returns in the future will not be distributed normally. The riskiest strategies that benefit most when the left tail of a distribution is cut is the riskiest strategies. ”Therefore, to make low volatility strategies in the future as attractive as they were in the past, the Fed put it would have to cease to exist. That seems unlikely, Baker said, for a variety of political and economic reasons. “I don’t think there will be going back,” he added. Baker said this does not mean that low volatility strategies have no role. to play in investment portfolios. But their role will have to change. We should now see them as a substitute for a portion of our fixed income allocation. Baker’s reasoning is that fixed income investors have limited options in a world where that the expected yield on bonds is below inflation. Instead of shifting our allocation from fixed income to particularly risky bond strategies, such as high yield durations or For the long term, we may want to invest some of that allocation in low-volatility stocks. There is no reason to expect these stocks to stop exhibiting low volatility, so in that sense they are somewhat similar to bonds. Unlike bonds, there is no particular reason to expect low-volatility stocks to lose ground when interest rates rise. To make an analogy, Baker imagines that we are being thrown into traffic. That’s, in effect, what the Fed is doing to force us to take risks, and it says the choice facing fixed income investors is between being pushed into “fast-moving or fast-slowing traffic.” Low volatility stocks are slow traffic. Mark Hulbert is a regular contributor to MarketWatch. Your Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com More: How to Make Money From Stocks, While You Sleep More: Equity investors are cautioned that reflation does not always lift the market