Mark Hulbert: Why the ‘Fed put’ makes low-volatility stocks an attractive replacement for bonds


Is it time to give up on low-volatility investment strategies? These strategies favor the stocks whose trailing returns are the least volatile. Not only do these stocks’ low volatility persist, on average, historically they have also gained more than the market itself. Higher return with lower risk is a winning combination.

But not last year. The Invesco S&P 500 Low Volatility ETF
for example, lost 1.4%, in contrast to an 18.4% total return gain for the SPDR S&P 500 ETF
That negative alpha of over 20 percentage points is more than twice as big as the next-worst year for this ETF.

This year hasn’t been any kinder to the low-volatility strategy. In the first quarter, the Invesco ETF had a negative alpha of 2.5 percentage points. In fact, as you can see from the chart below, SPLV’s trailing three-year alpha has been hovering near the zero line for close to 15 years.

For advice on low-volatility’s place in the current market environment, I turned to Nardin Baker, chief strategist at South Street Investment Advisers. Baker was the co-author (with the late Robert Haugen) of some of the first academic studies documenting the historical performance of low-volatility stocks. Perhaps the best-known of those studies — Low Risk Stocks Outperform within All Observable Markets of the World — showed that the low-volatility effect existed in each of 33 different country stocks markets over the period from 1990 through 2011.

I fully expected Baker to tell me that he thought last year represented nothing more than an exception to the otherwise impressive long-term rule. But he didn’t. In an interview, Baker said that both the U.S. economy and stock market have fundamentally changed in ways that greatly reduce the future attractiveness of low-volatility stocks.

Baker traces this change directly to the Federal Reserve’s easy-money policy. Because of that policy, investors face less risk when pursuing aggressive strategies than they otherwise would. They have confidence that “when the market gets risky, the Fed will step in to save the day and prop up the market,” he said.

This policy is known colloquially on Wall Street as the “Fed put.” As I wrote last fall in a column about a Duke University professor’s research, there is solid evidence that such a put exists.

Because of the Fed put, Baker reasoned, low-volatility strategies have become markedly less compelling. “When you eliminate the downside risk of a security, you’re basically telling investors that its returns going forward will not be normally distributed. What benefits the most when you cut off the left-hand tail of a distribution are the riskiest strategies.”

In order for low-volatility strategies in the future to be anywhere near as compelling as they were in the past, therefore, the Fed put would need to stop existing. That seems unlikely, Baker said, for a variety of political and economic reasons. “I don’t think there is any going back,” he added.

Baker said this doesn’t mean low-volatility strategies have no role to play in investment portfolios. But their role will have to change. We now should view them as a substitute for a portion of our fixed-income allocation.

Baker’s rationale is that fixed-income investors have limited options in a world in which bonds’ expected return is below inflation. Instead of shifting our fixed income allocation into particularly risky bond strategies, such as high-yield or long-term durations, we might instead want to invest some of that allocation in low-volatility stocks. There’s no reason to expect these stocks to stop exhibiting low volatility, so in that sense they are somewhat bond-like. Unlike bonds, there’s no particular reason to expect low-volatility stocks to lose ground when interest rates rise.

For an analogy, Baker imagines that we’re being pushed into traffic. That’s in effect what the Fed is doing in forcing us to take risks, and he says that the choice facing fixed-income investors is between being pushed into “fast-moving or fast-slowing traffic.” Low-volatility stocks are the slow-moving traffic.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at [email protected]

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