Risks are rising in one of the most reliable market-beating strategies

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Low-volatility investing has proved to be one of the more consistent ways to beat the market in recent years.

Such has been their persistent outperformance and resulting popularity that a growing faction is becoming more vocal about the risks of overcrowding in low-volatility funds.

Skeptics argue that low-volatility strategies have long been sustained by low interest rates and are ill-suited for a rising-rate environment.

But Jean Masson, a managing director at TD Asset Management who oversees several low-volatility funds, said that pessimistic take falls short on a number of fronts, not least of which is that a new era of substantially rising interest rates still seems a distant reality.

"Interest rates might rise a little bit, but they would still be very, very low," Mr. Masson said. "Is that enough to really hurt low-volatility funds? I don't think so."

The primary mandate of these kinds of funds is stability – to reduce fluctuations in value generated by market cycles while achieving comparable returns to a benchmark.

But in what has been characterized as an anomaly or an inefficiency of the market, low-volatility funds have generally generated superior returns to the broader market.

For example, the TD Canadian Low Volatility fund, which is managed by Mr. Masson, has generated an average 8-per-cent return annually over the past three years, compared with 6.8 per cent for the S&P/TSX composite total return index.

Meanwhile, dozens of low-volatility exchange-traded funds have come to market in the United States and Canada in the past several years, many of which have proved their value over a volatile stretch amid the commodity bust.

Over the past year, the two largest – the iShares Edge MSCI Minimum Volatility USA ETF and the PowerShares S&P 500 Low Volatility ETF – returned 10 per cent and 11.6 per cent, respectively, compared with 2.8 per cent for the S&P 500 total return index.

Unsurprisingly, investors have chased that performance, shovelling new money into low-volatility exchange traded funds.

The $13.6-billion (U.S.) iShares fund has doubled over the past year. In the first five months of this year alone, it took in $5.3-billion, which is more than any other equity-focused ETF, according to Bloomberg.

The kind of popularity has brought with it a new level of scrutiny.

In May, Deutsche Bank cited low volatility as among the most crowded investment strategies.

A recent report by New York money managers Greenline Partners found that over the past 50 years, low-volatility funds tended to outperform the market by one to two percentage points annually. But most of that time span saw interest rates trending downward. "We think this environment gave low-volatility investing a tailwind that will likely not repeat going forward," the report said.

In seeking stability, managers of low-volatility funds have tended to gravitate toward defensive sectors and bond-like securities, which are relatively attractive when interest rates are low. That preference has also generally excluded resource stocks in recent years, insulating low-volatility funds from the commodity correction.

A rising rate environment, on the other hand, may not favour the stocks and sectors now overweighted by the typical low-volatility fund. "Low volatility stock funds are probably the most dangerous thing out there," Jeffrey Gundlach, founder of DoubleLine, recently told the Financial Times.

But as the market changes, low-volatility fund managers will change their preferences, Mr. Masson said. "Sources of risk in the stock market migrate from sector to sector."

At least in theory, low-volatility investing is naturally resistant to crowded trades, Harry Marmer, a partner at Hillsdale Investment in Toronto, recently wrote in the Journal of Investing.

"As the herd chases these stocks, attempting to copycat a low-volatility-based strategy, the volatility of these stocks will increase and correspondingly these securities will exit the strategy," he said. "Of course, how fast these crowded stocks exit a strategy depends on the … investment process for a particular low-volatility strategy."