Low-Volatility Funds: The Wrong Way to Play the Rally?

Investors have grabbed onto the booming trend of low-volatility funds with both hands, and Wall Street has heard the message. Yet as an ETF giant launches two new funds geared toward low-volatility investing, investors have to be careful not to get caught up in what could be the late stages of another fleeting fad. As you'll see in more detail below, at some point, low-volatility funds could make safer stocks so expensive that they become a bad value proposition.

What's coming
Later this week, State Street plans to launch two new exchange-traded funds geared toward including companies whose shares move less violently than the overall stock market. The two ETFs will divide the market into large-cap and small-cap sectors, with each fund focusing on low-volatility stocks in its target market-capitalization segment.

State Street isn't the pioneer in the low-volatility fund universe. PowerShares has the biggest low-volatility ETF in the space, the PowerShares S&P 500 Low Volatility ETF (NYSEMKT: SPLV  ) with its large-cap targeting fund managing more than $3.7 billion, and the ETF management company recently issued related funds targeting mid-cap and small-cap stocks.

Why low volatility?
As this article discusses at greater length, multiple studies have shown that stocks with lower volatilities produce better performance over the long run than their more volatile counterparts. That result came as a surprise, as the capital asset pricing model predicts that the riskier an investment is, the greater its return should be.

The outperformance of low-volatility stocks doesn't come all at once, however. During big bull-market periods, they tend to lag behind more explosive high-volatility stocks, collecting more modest gains. But where low-volatility stocks shine is during downturns, when they fall much less sharply and preserve more of the gains they earned during better market conditions.

2 causes for concern
We've seen the shortcomings of the low-volatility strategy over the past year during the stock market's big rally. In 2012, the PowerShares ETF underperformed the S&P 500 by nearly 6 percentage points. Although some shortsighted investors would see that as a reason to discard the strategy, longer-term investors would only see it as indicative of the risk-reward spectrum that the ETF is designed to provide as market conditions change.

In fact, what may worry long-term investors more is the fact that so far in 2013, the strategy has managed to keep up with the booming overall stock market. In particular, with the rally pushing stocks to five-year highs, investors have gotten a lot more defensive, and they're bidding up prices of companies that have historically held up well during market reversals.

Looking at specific stocks within the low-volatility ETF's portfolio, Procter & Gamble (NYSE: PG  ) and Clorox (NYSE: CLX  ) both fetch nearly 20 times trailing earnings after having risen more than 10% in just six weeks, as the consumer-oriented companies expect their revenues to hold up even if an economic slowdown comes. Similarly, food giants Hershey (NYSE: HSY  ) and General Mills (NYSE: GIS  ) have gained more than 10% on speculation that the recent buyout of Heinz could lead to further merger and acquisition activity in the space. Yet Hershey is trading at an all-time high, with its trailing P/E nearly 30, and even looking out to fiscal 2014, its forward multiple is well above 20. General Mills has a more reasonable valuation, but it too has hit record highs for its stock.

Keep value in mind
No matter how fundamentally strong a company may be, its valuation makes a huge difference in whether its stock is a good investment. As interest in low-volatility stocks increases, the pricing discrepancies that result will lead to their valuations rising too high to reap the benefits of the strategy. Given that traditional growth stocks are trading at bargain valuations, you could argue that those disparities already exist.

When they're not popular, low-volatility stocks can be good buys for risk-averse investors. When high demand makes them too expensive, though, you'll be better off looking for more out-of-favor strategies that promise similar results.

Low-volatility or not, the best investing approach is to choose great companies and stick with them for the long term. The Motley Fool's free report "3 Stocks That Will Help You Retire Rich" names stocks that could help you build long-term wealth and retire well, along with some winning wealth-building strategies that every investor should be aware of. Click here now to keep reading.


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