In a world where most investors are falling over themselves looking for enhanced total returns, this fund takes a more mellow, long-term approach, writes Samuel Lee of Morningstar ETFInvestor.

In the slow-growth world, low-volatility stocks are king. They’re often quality companies offering essential services and are therefore less dependent on marginal economic growth.

With interest rates set to stay at zero for at least a couple of years, pension funds and many retirees are stretching for risk in the hopes of higher returns. They’ll probably be disappointed.

Power Shares S&P 500 Low Volatility (SPLV) bucks that tendency by owning less-volatile stocks and could be seen as the antidote to the “risk bubble,” as long as it isn’t being used to replace lost bond income.

Suitability
This exchange traded fund has a lot going for it. It implements a simple low-volatility strategy with very low fees.

Investors of all stripes can benefit from less-volatile stocks thanks to a puzzling phenomenon: Over the past 50 years, the least-volatile stocks have performed about as well as the market, but with far less risk. Low-volatility stocks have outperformed in most international stock markets studied, too, putting it up there with the value and size effects in terms of empirical support.

The most convincing explanation for low volatility’s performance involves leverage aversion. Investors who target above-market returns may be unwilling or unable to use leverage to reach their expected return targets.

By resorting to volatile stocks (more accurately high-beta stocks), which theoretically should outperform less-volatile stocks, investors hope to earn above-average profits. Ironically, their collective bet on high-beta stocks leads to low risk-adjusted returns.

There’s ample evidence this market inefficiency is real. However, low-volatility strategies can underperform during bull markets. ETFs like SPLV will likely produce great risk-adjusted returns over decade-long time horizons.

SPLV’s beta, or sensitivity to the market’s gyrations, is about 0.70—for each 1% move, SPLV will move in the same direction by 0.7%. This fund could serve as the nucleus of an investor’s stock allocation, but to fully benefit, investors should be willing to underperform during extended bull markets.

The rich world looks poised for another recession. Yet the US stock market is unattractively valued compared with its historical average. In order to combat depressed consumer demand, rich-world central banks have driven down real interest rates to punishingly low levels, inflating asset prices.

At a price of around 1,250, the S&P 500 yields about 2% and historically has grown real per-share dividends by about 1% to 2% annualized. If you add in share buybacks, a hidden boost to yield, equity investors are facing a prospective long-run 4% to 5% real return. To compound modest expected returns, longer-term challenges are cresting over the horizon.

Several factors will slow down the rich-world’s growth over the medium and long term: deleveraging, debt, and demographics. Consumers and banks are busy winding down debts, or deleveraging, at the same time; the result is a balance-sheet recession, a rare and long-lived situation that puts the economy in a fragile state. Low demand means businesses will have a hard time growing their profits, while governments take in less revenue and run deficits.

The growing government-debt load presages higher taxes for everyone—meaning, again, lower earnings for investors. Rich-world governments are also burdened with massive health-care liabilities. This is new territory; the world has never promised so much money to future generations while simultaneously experiencing a steep, coordinated decline in the ratio of workers to retirees.

The demographic headwinds introduce two major sources of uncertainty:

  • One is the upward pressure on the equity risk premium, or the reward investors demand for taking on stock risk. As investors age, they become more risk-averse, meaning they’ll demand higher future expected returns from risk assets. This will pressure equity prices down in order to bring their yields up to acceptable levels.
  • The second risk is the macroeconomic uncertainty introduced by the rich world’s policy response to the staggering promises it has made to the elderly.

Continued…

Tickers Mentioned: SPLV, USMV