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In this Oct. 8, 2014, file photo, people walk to work on Wall Street beneath a statue of George Washington, in New York.

Mark Lennihan/AP

As investors sift through the rubble from last week's equity rout, a blemish has appeared on what had been one of the hottest trades among quantitative investors -- low volatility.

The approach ostensibly offered protection from equity gyrations by betting on stocks that have historically swung less than the overall market. But when the S&P 500 Index registered its worst week in two years, exchange-traded funds geared to low volatility sold off nearly as forcefully.

The strategy fell victim to a spike in correlations among equities, as rising Treasury yields sent traditionally defensive shares sinking at a rate in near lockstep with high-flying growth stocks. The phenomenon may characterize coming selloffs, according to James Pillow, managing director at Moors & Cabot Inc., as the threat from higher rates looms over the equity market.

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"Many of these funds significantly overweight bond proxies and although those holdings have traditionally worked well in selloffs, as rates rally one should expect those beneficial correlations to break down," Pillow said. "As with many specialty ETFs, they more often than not fill an emotional need and not the actual need."

As the Cboe Volatility Index spiked by the most on record last week, the two most popular low-vol ETFs -- the the iShares Edge MSCI Min Vol U.S. ETF (USMV) and the PowerShares S&P 500 Low Volatility ETF (SPLV) -- fell at least 4.6 per cent in the five days through Feb. 9, barely outperforming the SPDR S&P 500 ETF Trust's (SPY) 5-per-cent slump. The low-vol funds command a higher fee than the index fund.

If history is any guide, the threat from higher rates bodes poorly for the performance of low-vol funds. Since launching in 2011, SPLV has typically underperformed SPY when 10-year Treasury yields climb.

A strategy like PowerShares's SPLV may be more sensitive to interest-rate moves because picking the lowest-volatility stocks without considering other risk factors can result in a hefty exposure to bond-proxy sectors such as utilities, according to Eric Balchunas, Bloomberg Intelligence analyst.

BlackRock Inc., the issuer of USMV, says focusing on one week of poor performance sparked by a Treasury selloff is too narrow of a lens. Over the fund's history, it's had a much higher correlation to stocks than to bonds, according to the firm's data.

"We always frame it terms of months and years instead of days and weeks," said Rob Nestor, BlackRock's head of iShares smart beta. "Because of stock-specific drivers, when you look at any given day or week, you see what appear to be odd-ball circumstances."

Low volatility ETFs rose to popularity over the past few years, reaching a record $47 billion in assets at the end of January, according to data compiled by Bloomberg. More than $700 million of that has flowed out so far in February, though not all of it in reaction to the equity selloff. One big investor pulled $436 million out the day before the swoon started, according to Nestor.

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Still, after two years of unprecedented calm failed to provide any sustained test for the low-vol strategy, last week's turmoil may have jolted some investors out of a false sense of security.

"At the end of the day, when vol spikes and correlations rise, even the so-called comfortable strategy of being long low vol or defensive sectors move in lockstep and pack a punch," said Josh Lukeman, head of ETF market making in the Americas at Credit Suisse Group AG. "Often what is the most comfortable thing to do, is the worst trade."

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