Not boring enough: Investors leave "low-volatility" funds

Economic IndicatorsAssociated Press

Whoa, give us back our money. We wanted something boring.

Continue Reading Below

That's what a growing number of investors are saying after joining the wave earlier this year into so-called "low-volatility" funds. These types of funds try to offer nervous investors a smoother ride, by buying stocks with a history of milder price swings than the rest of the market. Think power utilities, phone companies and other traditionally staid industries.

While these funds did help investors sleep easier early this year by falling less than broad-index funds when markets were sinking, their shakier performance since the summer has triggered the departure of billions of investors' dollars.

Consider what's happened to two of the largest low-volatility exchange-traded funds, the iShares Edge MSCI Min Vol USA ETF and the PowerShares S&P 500 Low Volatility Portfolio ETF. More than $8 billion flowed into them during the first seven months of the year, according to FactSet, as jittery investors searched for steadier options. Bonds are where investors traditionally go when they want something safe, but super-low interest rates mean they produce less income and put them at greater risk for losses.

Then, in late June, low-volatility funds passed a huge test after the United Kingdom unexpectedly voted to leave the European Union. The S&P 500 sank 3.6 percent the day after the vote, while the largest low-volatility ETFs lost only half that.

Given all the worries about the global economy, investors were happy with the trade-off inherent in low-volatility funds: milder drops when markets are down in exchange for more modest gains when the market is hot.

Even more investors poured into low-volatility funds as the summer heated up, and all the demand pushed prices higher for stocks with a history of less volatility. But the ascent meant these stocks were also growing more expensive relative to how much profit they produce, an important measure of valuation.

Utility stocks in the S&P 500 were trading at more than 21 times their earnings per share in July, for example. That was well above their average over the last decade of 15 times and high enough that some market watchers warned they were too expensive.

Since July, the tide has turned for low-volatility funds. Not only have they had worse returns than a traditional S&P 500 fund, they've also had sharper losses during the worst days.

On Sept. 9, for example, the two largest low-volatility ETFs lost 2.9 percent and 2.7 percent, when a broad S&P 500 index fund lost 2.4 percent. The low-volatility funds have also had more days where they've lost at least 1 percent than S&P 500 funds. Since the start of August, the low-volatility ETFs have lost roughly four times more than the S&P 500's 1.2 percent loss.

High valuations were only one of the reasons for the turnaround in performance. The utility and telecom stocks that low-volatility funds are full of are also among the types most at risk from rising interest rates.

AT&T, for example, is a top holding for both of the largest low-volatility ETFs. It had been doing well in large part because it pays a $1.92 annual dividend, and its 5 percent dividend yield is much higher than the 1.73 percent offered by a 10-year Treasury note. But, as interest rates rise, the worry is that income investors will sell AT&T and other high-dividend stocks when they move back to bonds. AT&T lost 3.6 percent on Sept. 9, more than the S&P 500, when speculation rose that the Federal Reserve will begin raising interest rates again.

Since the end of July, investors have pulled nearly $2.2 billion from the two largest low-volatility ETFs.

To be fair, the main job for these funds is not to lose less than the rest of the market. Instead, their objective is to track an index of stocks that have a history of being less volatile. And their real purpose may be something altogether different: To help keep nervous investors invested in the market, even when stocks are gyrating. History has shown that investors trying to time the market - by jumping in and out - often end up in worse position than those who simply stayed the course.

For now, though, investors want off the not-boring-enough ride.