Low-volatility funds are back in vogue after struggling in pandemic

Roughly $6.5 billion has poured into low-volatility mutual and exchange-traded funds this year, putting the funds on track for their first annual inflows since 2019, according to Morningstar Direct. Low-volatility funds promise a smoother market ride by holding stocks with the smallest one-day swings—higher or lower. That bias often lends itself to shares of utilities, consumer-goods and real-estate companies that tend to be less sensitive to economic booms and busts.

The iShares MSCI Min Vol USA ETF—the largest low-volatility fund—has raked in more than $1 billion in assets in the past month, according to FactSet. Those inflows make the fund among the most popular of all U.S. equity ETFs as worries of more aggressive monetary tightening by the Federal Reserve have marred the outlook for stocks. The S&P has fallen 5% in the past month, extending its losses for the year to 21%.

Assets under management at the iShares fund have climbed to $28 billion, though that is down from a peak of $40 billion in February 2020.

Low-volatility funds sprouted up in the wake of the financial crisis of 2007-2009 and grew exponentially in the years following. But that came to a halt at the start of the pandemic when the funds tumbled sharply in conjunction with the market’s broad-based selloff, failing to provide a haven for investors.

Even when markets began their furious rebound, low-volatility funds didn’t take part. The stocks that led the way were in sectors like e-commerce, which traditionally are more susceptible to market swings and thus less represented in low-volatility funds. Frustrated with underperformance during both the market downturn and rally, many investors headed for the exits.

“The troubling thing with low-volatility strategies is what we experienced in 2020, an episodic and extreme bout of volatility," said Matthew Bartolini, managing director at State Street Global Advisors and head of SPDR Americas Research. “Everything dropped significantly, all at the same time. Then there was a big rally in higher-risk stocks, but not so much for lower-risk stocks."

Low-volatility funds face another issue common among ETFs: Although many advertise similar strategies, some investors warn that it is important to look under the hood of the funds because their compositions—and performance—can vary widely.

For example, the iShares fund from BlackRock Inc. follows an MSCI index that selects stocks not only based on volatility, but also their correlation to other stocks. Further constraints, such as preventing sector weightings from straying more than 5% from that of the index, result in a fund that resembles the broader market. The iShares fund counts tech stocks such as Cisco Systems Inc. and Texas Instruments Inc. among its top holdings.

On the other hand, the Invesco S&P 500 Low Volatility ETF tracks the 100 stocks in the S&P 500 with the lowest variation in returns over the past year irrespective of their sector. With $11 billion in assets under management, Invesco’s fund is the second largest low-volatility fund on the market.

“Low-volatility ETFs can end up with very different outputs," said Corey Hoffstein, chief investment officer of Newfound Research. “Oftentimes investors want a specific exposure, but then select a specific manager without realizing how much performance can differ—and that dispersion can be tens of percentage points."

In 2022, both funds are beating the S&P 500. The iShares fund is down 15%, while the Invesco fund has fallen 11%. Back in 2020, both funds significantly underperformed the broader market. The iShares fund returned 3.5% and the Invesco fund lost 3.6%, while the S&P 500 gained 16%.

Wall Street appears to lack consensus on the outlook for low-volatility strategies. Some say the uncertain macroeconomic environment gives those funds more room to run. Others question the efficacy of picking stocks based solely on their historical volatility.

For Rob Arnott, founder and chairman of Research Affiliates, it is all about relative valuation, or whether an asset is cheap or expensive with regard to the broader market.

Mr. Arnott, a pioneer of strategies like low volatility that attempt to beat standard market-tracking funds, said the recent rebound is no coincidence. He said those strategies fell in the fourth quarter of 2021 to their widest discount relative to the broader market since the 2000 dot-com bubble.

“Valuations are fairly in line with historical averages, so I would not say to avoid low volatility, as I did in 2016," said Mr. Arnott. “But as people who are fearful about the market turn to low-vol rather than exiting all together, we could expect those flows to push valuations much higher."

Some strategists say inflows may not abate anytime soon, either.

“These strategies are working this year, and that is part of why people are moving money," said Todd Rosenbluth, head of research at VettaFi. “But it is a fair expectation that the remainder of 2022, and into 2023, is going to remain volatile. The Federal Reserve is still raising interest rates in the ongoing global battle against inflation, the war in Ukraine continues, and election season is upon us."