Lately, many investors have sought protection from a potential downturn by turning to low-volatility stocks, which they perceive as somehow being safer than higher-volatility stocks. Yet even among the 30 blue-chip stocks in the Dow Jones Industrials (DJINDICES:^DJI), you'll find that low volatility is no guarantee of protection during downdrafts in the overall market.
Why low volatility seems appealing
Over the past year or so, low-volatility stocks have gained notoriety as being better long-term performers than their higher-volatility counterparts. Several studies have established that when you look at long-term returns, low-volatility stocks often produce better results than high-volatility stocks, even though the greater risk involved with high-volatility stocks should theoretically reward investors with higher returns.
But often, phenomena such as low-volatility stock outperformance prove vulnerable once investors grab onto strategies that seek to exploit historical share-price behavior. Recently, we've seen exactly that vulnerability within the Dow.
A short-term reversal of fortune for low-vol stocks
From May 28 to June 5, the Dow dropped almost 450 points, or about 3%. Based on past history, what investors would have expected was for low-volatility stocks to post more modest declines while high-volatility stocks dropped more sharply.
Yet the actual returns of many of the Dow's components point to the contrary. Pfizer (NYSE:PFE) and Procter & Gamble (NYSE:PG) both lost more than 5% despite having betas that would suggest only half the volatility of the overall market. Verizon (NYSE:VZ) also weighed in with an almost 5% pullback even with a beta of 0.8.
Has the low-vol strategy stopped working?
The key to understanding these results rests on a few observations. First and foremost, judging a long-term strategy over a period of a single week is completely unreasonable. Even a fully functional strategy can produce aberrant results in the short run.
But the other thing to note is that as these low-volatility stocks have gotten popular, their prices have risen. In particular, P&G has the distinction of being in the defensive consumer-staples industry, which has been a place where many investors have turned looking for safety. Similarly, Pfizer and Verizon are both high-dividend stocks, which have been in high demand given the low interest rate environment. An upturn in bond yields has weighed on many dividend stocks, even those with relatively low volatilities.
Don't jump to conclusions
The key takeaway from the current behavior of low-volatility Dow stocks is that even a completely valid strategy can produce undesirable results when it gets too popular. Long-term investors should actually hope that more short-term-focused investors lose faith in the low-vol strategy, as that would make the strategy more likely to work in the future.