The hidden risk of low-volatility investing

Low-volatility strategies tend to be more sensitive to fluctuating interest rates than the broad market.

Alex Bryan 14 March, 2017 | 5:00PM

Interest rates have a powerful impact on security prices. As rates rise, the expected rate of return for all securities must increase to compete for investors' money. This adjustment can be painful because it often requires prices to fall. Fixed-rate bonds are the most obvious example. Because their cash flows are fixed, the entire return adjustment must come from falling prices. Stocks are also affected by interest rates, but the impact is more difficult to anticipate because, unlike bonds, stocks do not have a finite life or fixed cash flows. However, their interest-rate sensitivity should be positively related to the stability of their cash flows. Consequently, low-volatility stocks should be highly sensitive to changing interest rates.

Interest rates do not change in a vacuum. They tend to increase as the economy strengthens and central banks become concerned about inflation. Conversely, rates tend to fall when times are tough and demand weakens. Corporate profitability also fluctuates with the business cycle. Firms that are more sensitive to the business cycle tend to experience greater cash flow growth during economic expansions. As a result, they should do better when rates rise than their less-cyclical counterparts. But their cash flow also tends to contract more during economic downturns, when rates are most likely to fall, offsetting the benefit from lower rates. This suggests that stocks with more-stable cash flows should be more sensitive to interest rates.

Consistent with this theory, I published an article a few years ago showing that high-dividend-yielding stocks, stocks in more-defensive industries and large-cap stocks tended to be more sensitive to changes in interest rates than their lower-yielding, more cyclical and smaller counterparts. To test the idea more directly, I extended this analysis to a few low-volatility indexes of U.S. stocks, including the S&P 500 Low Volatility and MSCI USA Minimum Volatility indexes. These indexes underlie  PowerShares S&P 500 Low Volatility ETF (ULV.F)/(SPLV) and iShares Edge MSCI Minimum Volatility USA (XMU)/(USMV), respectively.

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About Author

Alex Bryan

Alex Bryan  Alex Bryan, CFA, is director of passive strategies for North America at Morningstar. Before assuming his current role in 2016, he spent four years as an analyst covering equity strategies. He holds an MBA with high honors from the University of Chicago Booth School of Business.

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