Low volatility ETFs are enjoying heavy net inflows in 2019, as nervous investors anticipate higher market turbulence ahead. “There is a bank of evidence--accumulated since the 1970s--showing that less volatile stocks posted higher risk-adjusted returns across a number of time horizons, regions, and market segments, historically,” per a recent report by Hamish Preston of S&P Dow Jones Indices, as quoted in Barron's.

“Low-vol tends to perform the best when the economy is decelerating or contracting,” as Nick Kalivas, senior equity product strategist at Invesco, told Barron's. “Weak economic conditions are favorable for low volatility,” he added.

For the year ending July 1, 2019, net asset value (NAV) rose by 19.14% for the Invesco S&P 500 Low Volatility ETF (SPLV) and by 19.03% for the iShares Edge MSCI Min Vol USA ETF (USMV), versus a total return of 11.27% for the S&P 500 Index (SPX), per Morningstar Inc. The iShares fund has seen net inflows of about $5.7 billion since the start of 2019, while the Invesco fund has pulled in about $2 billion, increasing their assets under management (AUM) by roughly 25% and 20%, respectively, per Barron's.

Significance for Investors

From February 1972 to May 2019, the S&P 500 Low Volatility Index has generated an average annual total return, with dividends reinvested, of 12.3%, while the S&P 500 returned 10.3%, per analysis by S&P Dow Jones Indices cited in the same article. “The access to low-volatility anomaly is something that can reward the investor over long periods of time,” as Kalivas told Barron's.

Conventional wisdom holds that riskier stocks should deliver higher returns, hence the anomaly. However, portfolios with smaller losses during market downturns can outperform those with bigger gains during rallies. For example, a portfolio that rises by 100% in one period but falls by 50% in the next will be unchanged on a cumulative basis. By contrast, another portfolio that is half as volatile, up by 50% then down by 25%, will record a cumulative gain of 12.5%.

The Invesco Low Volatility ETF has outperformed the S&P 500 by a wide margin across the last 12 months is precisely for this reason. During up periods in that time span, its gains have been 96% of those enjoyed by the S&P 500 as a whole (much better than its long term average of 75%), while it has fallen by only half as much as the market during down periods, Barron's notes. Adding to their defensive characteristics, low volatility stocks often have above-average dividend yields, Yahoo Finance indicates.

By sector, the Invesco ETF is 24% utilities, 23% financial services, and 19% real estate, per Morningstar. The iShares ETF is more diversified: 15% financial services, 13% consumer defensive (staples), 12% industrials, 11% health care, 10% technology, and 10% consumer cyclical (discretionary).

Looking Ahead

The rush by investors into low volatility ETFs has bid valuations of the underlying stocks above the broader market. The Invesco Low Volatility ETF has a 12-month trailing P/E ratio of 22 times earnings, above both its 5-year average and 18.6 for the S&P 500 as whole, according to FactSet Research Systems data cited by Barron's.

However, the subsequent performance of low volatility stocks has no historical correlation with their starting valuation levels, according to Hamish Preston of S&P. As long as demand remains high for these stocks, valuations should remain high as well.