In the 1970s, unexplained phenomena were having a moment – consider the Bermuda Triangle, Bigfoot and UFOs. And on Wall Street, certain whizzes were delighting in another, the low-volatility anomaly.
Research began to show that low-volatility stocks were undermining the entire premise of investing – that high rewards come with high risks.
Today, low-volatility shares in consumer-goods companies, utilities and other garden-variety businesses often outperform the stock market as a whole. They may not see the soaring highs when the market is rising, but they also tend not to experience the searing lows when the market turns bearish. And investors have caught on.
Yet, some experts have noted the inevitable paradox: If low volatility means high popularity, those stocks could rise in price and the fund will no longer provide as high a return.
A low-volatility strategy hinges on stable shares offering good value for the money. But "it's relatively expensive at this time, so that would suggest its returns will be disappointing," said value-investing specialist Tim McElvaine of McElvaine Investment Management in Victoria.
Some view the phenomenon differently, however.
"I would probably flip that on its head and say we actually should be willing to pay a little bit more for the better peace of mind of staying invested in markets and not having to worry as much about day-to-day risk," said Mark Raes, head of product at BMO Global Asset Management in Toronto.
In other words, as with any safe-haven investment, investors will pay a premium for reduced risk. And at least with low-volatility equity funds, they might shrug off downturns and stay invested for the next upswing.
For more aggressive investors, this approach requires patience. "We all want to find that million-dollar opportunity, the home-run stock. And we have a disposition toward investing in that stock, whereas the more slow and steady names we tend ignore," Mr. Raes said.
The definition of "low" in low volatility depends on which broader market you are comparing a fund to. Energy and resource companies are so prominent in Canada's S&P/TSX Composite Index that drastically reducing holdings in those types of stocks can easily reduce risk by about 30 per cent. So if the overall TSX plunged 10 per cent, a low-volatility fund might drop by only 7 per cent.
With other indices that are more balanced, however, reducing risk can be more difficult. For instance, a low-volatility fund might offer just 20 per cent to 25 per cent less risk than the S&P 500 Index, which represents a broader swath of companies in a variety of industries.
"At the moment, if you looked at the less volatile sectors, you would definitely go to utilities, consumer staples, groceries and drugstores, and then telcos, some insurance names, some REITs [real estate investment trusts], some banks. These are what we hold in our funds," said Jean Masson, managing director at TD Asset Management in Toronto.
One caution is a fund's sensitivity to interest rates. Rates are historically low, so they haven't played much of a role. But utilities and certain real-estate investment trusts are often staples in a less volatile portfolio, and they may incur added risk when rates rise because they typically carry a great deal of interest-rate-sensitive debt.
The lesson is that low-volatility funds are not simply buy-and-hold investments. Periodic readjustment of assets might be necessary to keep risks low in a broader market.
"But the flip side of interest-rate sensitivity is that [rising rates] also indicate that the economy and markets are doing well," Mr. Raes said.
Fund managers take varying approaches to low volatility. Some concentrate on stocks themselves, measured in statistical terms such as standard deviation. Others use a basket of stocks relative to the market as a whole. That's termed beta. Mr. Raes emphasized that BMO focuses on the beta.
"We think that with a low-volatility strategy, first and foremost, you're trying to protect yourself from those market downturns," he said. "I think you're trying to smooth out market returns. So, you lose a little bit on the upside when markets are doing really well, but you protect on the downside when things are really heading south."
Different types of investors are interested in low volatility. Some are attracted to the funds and stay put because they think these vehicles "produce better returns per unit of risk. These people never go away," Dr. Masson said.
Others might be buying low-volatility equities because "they have returned more than other types of equities of late," he said. "These are people who are basically chasing past performance. That's not the right reason to buy low-volatility equities.
"The right reason is that you don't want to lose [when the market drops]," he said.
Low volatility, therefore, offers relative steadiness, sometimes outperforming the market, sometimes not. This can actually act to the advantage of low-volatility funds by making them not so popular that their prices rise and undermine their effectiveness.
"If the market is hot, these funds sometimes underperform a little bit. That doesn't mean they lose money. They just don't do as well as the best," Dr. Masson said. "So if you look at ETFs [exchange-traded funds] and mutual funds and so on, they grow and then they shrink a little bit, and then they grow again. But over all, this form of investment is growing."