Low Volatility Stocks Usually Do Well—But There Are Traps

Thinking that these are safe bets, investors don’t realize they can carry other risks, warns Northern Trust Asset Management.

After the series of market debacles that have beset this century, the common wisdom—backed by academic research—is that low-volatility stocks tend to do better over time than the high-tempo kind. After all, shares whose trading activity is steady are by definition less risky than those that shoot all over the place.  
But a Northern Trust Asset Management research paper sounds a warning note about low-vol names. Some of these steady Eddies can lead investors astray, particularly in real estate, utilities, and consumer staples, the firm says. Note that these are customarily labeled defensive sectors.
High volatility has been the stock market’s lot this year, as the S&P 500 slumped 10.4%. The CBOE Volatility Index, or VIX, is at 28 as of Friday; in early March, it had shot up to 36. The VIX is usually in the high teens.
The undergirding thesis supporting low-vol stocks is reassuring. They outperformed the market (the MSCI Word Index) and high-vol equities by 0.8% and 2.1% annually, from 1996 through 2021, NTAM finds. This is in keeping with numerous academic studies that found the steady cash flows and price expectations, among other attributes, lead to better performance over time. A well-known study by economist Pim van Vliet, of Robeco Investment Management, backs up that notion.
The problem, in NTAM’s eyes, is that the reassuring low-vol narrative can lull investors into traps. Interest rates, now on the upswing, can do damage to low-vol holdings, says Mike Hunstad, NTAM’s head of quantitative strategies.  
Real estate and utilities carry a lot of debt, and the escalating cost of borrowing can harm them, he says. Consumer staples are vulnerable to economic risk, Hunstad adds. While usually regarded as recession-proof, the staples can still take a hit on lower revenue and earnings.

The remedy, according to Hunstad, is to focus on companies with strong cash flows, profitability, and balance sheets. “You want high-quality stocks,” he says.
Indeed, Northern Trust manages an exchange-traded fund called FlexShares US Quality Low Vol that focuses on just these types of stocks. The ETF is down 5.7% in 2022, about half the S&P 500’s drop, per Morningstar. Its beta, of 0.99, indicates that it is slightly less volatile than the market.

Its top three holdings are two tech giants and a pharma megalith: Microsoft and Apple, which are down this year worse than the market, but over five years have more than quadrupled, and Johnson & Johnson, which is up 5.8% in 2022 and over five years has advanced by a half.

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