We’ve written extensively about the popularity and outperformance of low-volatility ETFs in a market that favors defensive sectors, but how much longer can the party last?
For example, PowerShares S&P 500 Low Volatility Portfolio (NYSEArca: SPLV) and iShares MSCI USA Minimum Volatility ETF (NYSEArca: USMV) have together gathered $9 billion in assets in less than two years since they launched, according to Morningstar.
The low-vol ETFs are also outperforming the market as measured by the S&P 500 this year with conservative sectors such as utilities, consumer staples and healthcare leading the way.
However, investors who have recently piled into low-volatility ETFs may end up disappointed if there is a sector rotation away from defense and cyclical sectors start pacing the market.
“The rally is not about low-vol, it’s about value stocks and dividends versus growth stocks and cyclicality,” says Josh Brown at the Reformed Broker blog.
“This year, there’s something new happening, where nongrowth stocks are being pushed up toward growth multiples because of their ability to substitute for expensive bonds and return lots of cash,” Brown told IndexUniverse.
After being overweight in defensive, value stocks for two years, he says he’s now far more interested in cyclicals, which are hated.
“Once the market gets bored of paying 20 times earnings for candy companies and utilities, we’ll be waiting for the rotation,” Brown added.
So low-volatility ETFs have been very popular with investors so risk-averse after the financial crisis, and the strategy has outperformed. The question is how much longer the trend can continue.
Next page: Low-volatility vs. mega-cap
For investors who do want to stick with a low-volatility approach, Morningstar notes that mega-cap stocks may be an even simpler way to implement the strategy.
Morningstar analyst Michael Rawson points out that over the past decade, mega-cap stocks have been a bit less volatile than the S&P 500, although the asset class not exhibited the same outperformance of pure low-volatility strategies.
Yet in the current environment, mega-cap ETFs could be a better choice than low-volatility strategies that are often concentrated in defensive sectors that are looking pricey.
“Clearly, portfolios of less-volatile stocks have a performance edge over the long run, but is now a good time to invest in this strategy? Low-risk stocks and those with a high dividend have had excellent recent returns, but they are beginning to look expensive,” Rawson wrote.
“We like the benefits of the low-volatility strategy, but based on valuation, a better approach at the current time is to invest in mega-cap stocks,” he added.
Mega-cap ETFs include iShares S&P 100 (NYSEArca: OEF), Guggenheim Russell Top 50 Mega Cap (NYSEArca: XLG), SPDR Dow Jones Industrial Average (NYSEArca: DIA) and Vanguard Mega Cap (NYSEArca: MGC).