“perhaps the greatest anomaly in finance”

The financial blogosphere has been talking about the Low Volatility Anomaly forever. The anomaly, referred to as “the greatest” and “the last” given it’s staying power and refusal to go away, shows that over long stretches of time equity investors are actually rewarded more for taking less risk (holding quieter stocks) than for taking more risk (with exciting growth stocks).

This concept flies in the face of centuries-old investing wisdom and even basic human common sense! Since our earliest primitive ancestor braved the beehive to bring home sweet, sweet honey to his mate and children, we’ve been hardwired to believe that Fortune Favors the Bold (as the poet Virgil told us) and that only by going out on a limb could we ever truly find great success.

In what other endeavor are we taught that big rewards come with lower risk? And yet the persistent long-term outperformance of Low Volatility stocks stares us right in the face each day, any time we look at the data.

The way this works – according to the academic literature produced on the topic (reams and reams of it) is that investors tend to overpay for growthier and sexier stocks, which then underperform as promised growth projections fall short and gravity goes to work on those excessively rich multiples. In the meantime, lower volatility stocks keep chugging along and rarely fall prey to huge swings given the “margin of safety” inherent in low-multiple, modestly valued companies.

The ETF arms dealers have been steadily churning out funds this year to capitalize on the phenomenon. They actually get two bites of the apple:

a) First they can show how the anomaly generates a steady, non-ostentatious alpha over the years.

b) then they can pitch it to risk-averse investors who need to buy stocks but can’t stomach the swings of full-blown beta given the Post Traumatic Stock Syndrome that remains so prevalent amongst the investor class.

The most well-known vehicle in the low-vol space is SPLV – essentially a basket of the steadier, more defensive names in the S&P (utilities, consumer staples, etc). The fund is two years old and has raised an impressive $4.1 billion since launching, no easy feat in such a noisy ETF marketplace.

John Spence’s latest blog post on the subject at ETF Trends shows us that SPLV no longer has the field to itself – the new entrants are rolling off the assembly line like gleaming new automobiles…

Other low-volatility ETFs include iShares MSCI USA Minimum Volatility ETF (NYSEArca: USMV), PowerShares S&P International Developed Low Volatility (NYSEArca: IDLV) and iShares MSCI Emerging Markets Minimum Volatility (NYSEArca: EEMV).

State Street (NYSE: STT) recently launched its first low-volatility ETFs: SPDR Russell 2000 Low Volatility ETF (NYSEArca: SMLV) and SPDR Russell 1000 Low Volatility ETF (NYSEArca: LGLV).

The one caveat I want to add (that I’ve not seen mentioned elsewhere) is that, these days, traditionally low volatility stocks are not quite as cheap as they used to be.

Utilities and Telecoms – which are frequently loaded into these low-vol products – are two of the most expensive sectors in the S&P on a PE multiple basis right now. These stocks are trading at high valuations historically on both a relative and absolute basis – thanks to their perceived safety and high dividend yields. Utilities trade at 16 times trailing earnings versus the S&P 500’s multiple of 15.25 – and don’t even get me started on Telecoms at 23 times last year’s earnings, an absurdity to be sure.

What future effect this Fed-induced perversion will have on the low-vol indexes and products that hold these securities in size remains to be seen.

The other thing to keep in mind is that in a true bull market – one in which cyclical stocks and growth stocks enjoy expanding earnings and multiples – you can expect so-called low-vol stocks to get hit as investors exit to chase the shiny stuff. Flight from Utilities would especially knock down the share price of SPLV as it currently carries a 30% weighting to the sector, or 10 times the weighting the S&P 500 gives these stocks.

Just be forewarned, there is no such thing as “works all the time” – low volatility or otherwise.

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