One month ago, we cautioned readers that according to recent fund flow data, Bank of America was convinced that the “next shoe to drop” would be so-called “low-vol” stocks, ETFs and related strategies, which due to their debt-like characteristics and steady dividend payouts, had emerged as one of the preferred hangouts during the period of turbulent in the early part of the year.
As BofA Savita Subramanian explained, low volatility strategies had seen a parabolic increase in inflows since late 2014 as investors chased the perceived safety of these strategies. These inflows helped push valuations in Staples and Utilities to elevated levels.
However, the stratgist warned , investor sentiment appears to be shifting from a deflation / low growth theme, which benefited defensives and yield plays in 1H16, to an inflation theme, with interest rates rising, inflation expectations picking up and fiscal stimulus beneficiaries attracting investor interest. As such, Utilities and Staples, which have been two preferred sectors for low vol strategies, were two of the worst performing sectors (along with Telecom) in Q3.
In August, Low Vol funds experienced their first outflow since September of 2014 and appear vulnerable to more outflows if their perceived safety deteriorates as investors shift their focus away from ZIRP (zero interest rate policy) beneficiaries.
As a result of these shifts, BofA concluded, “low vol” has become more risky: the realized volatility of low beta stocks has seen a steady increase over the past several years as shown in the chart below, suggesting low vol is becoming high vol.
Ironically, “low vol” was becoming “very high vol.”
And then, after last week’s victory by Donald Trump which unleashed the great Trumpflation rally, the not so low vol went off the charts, and the shoe officially dropped, and as Bloomberg pointed out earlier today, the “Low Vol” iShares Edge MSCI Min Vol EAFE ETF saw a record one-day outflow of more than $300 million on Wednesday.
The first warning was June’s Brexit vote: “Brexit killed low-volatility — that was the catalyst. People just breathed a sigh of relief after that point,” said Eric Balchunas, ETF analyst at Bloomberg Intelligence. However, thanks to the market’s brisk rebound after Brexit courtesy of central bank backstops, the scare was not enough, and investors continued to flock inside into the “safety” of low vol ETFs, boosted by the funds’ better performance than the overall market in the first half of 2016.
However, as Bank of America noted last month, the low vol outperformance ended some time around mid-July, at which point the group started to underperform the S&P.
As Brean Capital’s Head of Macro Strategy Peter Tchir put it after the fact, “something got lost in translation. People, I think, started viewing it as ‘all the upside of equities with limited downside’ — they got the opposite — time to sell. This product attracted extremely risk averse investors — when risk popped up here ‘unexpectedly’ (I think completely predictably) the holders now sell as they didn’t want risk in the first place.”
So is it safe to write out “low vol” as a strategy? As long as the Trumpflation-inspired selloff in bonds continues and yields – together with the dollar – keep soaring, the answer for both dividend and “low vol” strategies is a resounding yes. However, once financial conditions as a result of the unprecedented chase of coming inflation (which as we explained earlier may not come at all, and will likely only arrive some time in 2018) become so tight that not even the quant community can keep chasing momentum with incremental leverage, all the money that is currently flooding out of the abovementioned products will rush right back in, and the cycle can begin from scratch.
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