Is There A Bubble In Low Volatility Funds?

Investors have been pouring money into low volatility funds at a record pace so far in 2016. According to Bloomberg low vol funds have seen higher fund flows than any other ETFs which has prompted some people to wonder if there’s a bubble in low vol funds.

Low volatility funds try to capture what’s called the low volatility anomaly which shows that some stocks with lower than average volatility tend to outperform the market.¹ They do so primarily by capturing exposure to defensive sectors of the stock market which typically leads to a significant weighting in consumer defensive names. In fact, the largest low vol ETFs mirror a consumer staples ETF like XLP with near 100% accuracy.

(XLP vs SPLV since inception)

More importantly, consumer staples and low vol stocks have beaten the S&P 500 by 13% over the last 5 years (since the inception of these real-time ETFs). If you look at a fund like Vanguard’s Consumer Staples Admiral share we find that this outperformance has persisted for over 10 years. More interestingly, consumer defensive stocks fell just 34% during the financial crisis while the S&P 500 fell over 50%. Therefore, you did in fact see real-time outperformance in both nominal and risk adjusted terms across these time periods. But there is good reason to be skeptical of this performance going forward: