The Hidden Risk of Low-Volatility Investing
Low-volatility strategies tend to be more sensitive to fluctuating interest rates than the broad market.
A version of this article was published in the January 2017 issue of Morningstar ETFInvestor. Download a complimentary copy of ETFInvestor here.
Interest rates have a powerful impact on security prices. As rates rise, the expected rate of return for all securities must increase to compete for investors' money. This adjustment can be painful because it often requires prices to fall. Fixed-rate bonds are the most obvious example. Because their cash flows are fixed, the entire return adjustment must come from falling prices. Stocks are also affected by interest rates, but the impact is more difficult to anticipate because, unlike bonds, stocks do not have a finite life or fixed cash flows. However, their interest-rate sensitivity should be positively related to the stability of their cash flows. Consequently, low-volatility stocks should be highly sensitive to changing interest rates, as the remainder of this article will demonstrate.
Alex Bryan has a position in the following securities mentioned above: USMV, XSLV. Find out about Morningstar’s editorial policies.