In Fighting chance, we highlighted a report from PwC that suggested assets held globally in exchange-traded funds (ETFs) would exceed $7 trillion (£5.4 trillion) within the next five years. Whatever the actual figure turns out to be, it will be interesting to see how much of the total is made up of assets in so-called low-volatility ETFs.
According to a recent MarketWatch opinion piece, “more than $50bn has poured into low-volatility indexed exchange-traded funds over the past five years or so, in the wake of the 2008/09 market meltdown”. The article also quotes statistics from ETF,com that show six ETFs in the “lo-vol” space boasting assets of more than $2bn each, with the largest now past the $15bn mark.
Tie that in with two recent headlines from the Financial Times – European funds see record withdrawals ($5.8bn in the week to 13 July, ostensibly on worries about the Italian banking crisis) and Bond ETF funds attract $73bn this year (as yield-hungry souls eye the prospect of more monetary easing) – and clearly a lot of investors are hoping for a gentler ride than they have enjoyed of late.
But just how realistic are such hopes? In some ways, the thinking is tough to fault – the Brexit vote has provided yet another reason for interest rates around the world to stay lower for longer and investors are on the hunt for supposedly safer assets that do not have the negative yields that are becoming, as we saw in Minus sign, such a feature of the sovereign debt market.
And yet, as the MarketWatch article illustrates, much of that hunt for supposed safety is taking place in the passive sector – in funds that by definition buy the largest stocks, that buy yesterday’s winners, that buy, say, the UK’s tobacco sector on a cyclically-adjusted P/E ratio (CAPE) of around 28x today rather than the 14x it was on 15 years ago as the likes of British American Tobacco began their stellar run.
Low volatility funds work to minimise market swings but they do so at a cost – and that cost is a complete disregard for valuation. As we never tire of pointing out, here on The Value Perspective, that is a dangerous bet at the best of times and, with US markets once more nudging record highs and more and more investors all facing in the same direction, these are hardly the best of times.
The disparity in valuations between the cheapest and the most expensive parts of the equity market are extreme. Yes, we have been arguing this for some years now, but it is only growing more extreme as the premium paid by large parts of the market for the perceived safety of many traditionally defensive stocks – the likes of BAT and also much of the food and beverage sector – continues to rise. Ignore valuation and the wider market’s desire for peace of mind could end up proving very stressful indeed.