Investors flee some low-volatility funds — possibly at worst time

Low volatility funds saw big inflows last year because they promised to protect investors from big swings in the stock market. Now the tide is turning in the other direction — and possibly at the exact wrong time.

Low volatility funds and ETFs simply invest in stocks with the lowest moves up and down over a set period. The $12.3 billion iShares Edge MSCI Min Vol USA ETF (USMV), for example, looks for large- and mid-sized stocks which have lower volatility than the rest of the market. In theory, these funds should deliver decent returns with below-average volatility.

By and large, they have done just that. The iShares offering, for example, gained 10.6% last year versus 12.0% for the Standard & Poor’s 500 stock index with dividends reinvested. The fund has a three-year standard deviation of 8.61 versus 10.4 for the S&P 500.

The fund has trailed the S&P 500 so far this year, gaining 5.7% versus 6.1% for the blue-chip index. And investors have been fleeing. Morningstar estimates that a net $704.3 million has fled the ETF this year through the end of February. The next-largest low-vol ETF, PowerShares S&P 500 Low Volatility Portfolio (SPLV), has watched an estimated $207.8 million flee this year.

The selling from low-vol funds and ETFs hasn’t been uniform: Some, such as PowerShares S&P 500 High Dividend Low Volatility Portfolio (SPHD), have seen significant inflows this year. But the outflow from some of the largest ETFs is noteworthy.

What’s sending investors to the exits? Two possibilities. The first is that some low-volatility ETFs stock up on utilities and banking stocks. Utilities tend to be a safe haven in a down market and, because of their high dividends, often attract long-term income-oriented investors. Financial stocks also tend to be stable, unless of course, there’s a financial crisis.

Both sectors, however, also tend to be sensitive to changes in interest rates. Investors typically see utilities stocks as bond substitutes, and when interest rates rise, utilities often short-circuit. Banks are more dependent on the spread between long-term and short-term interest rates: When the spread narrows, banks earn lower profits on loans. Given that the Federal Reserve is likely to continue raising short-term interest rates this year, low-volatility funds are less attractive.

A more simple reason for low-volatility strategies to lag: Volatility has been remarkably low, says Dave Nadig, CEO of ETF.com. The CBOE VIX index, for example, stands at 11.71, down from more than 25 in June. The iPath S&P 500 VIX Short-Term Future ETN (VXX) has fallen 79.4% the past 12 months.

“I think a lot of people went to low-vol funds because they saw them as an outperformance tool, rather than a way to reduce portfolio volatility,” Mr. Nadig said. “But in a period of low volatility, they don’t outperform, and that hot money goes out.”

Given that the market has been so calm, it’s likely investors are bailing at the wrong time, Mr. Nadig said.

“I fully expect to see the highest peak of selling to come just before we see the VIX spike to 25,” he said.