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By Christine Benz and John Rekenthaler | 07-15-2013 12:00 PM

Are These Investment Trends Just Fads?

Morningstar's John Rekenthaler offers his take on whether market hot spots, such as low-volatility funds, alternatives, and multi-asset-class income vehicles, have long-term staying power.

Christine Benz: Hi. I’m Christine Benz for Much like the apparel industry, the investment industry is often quick to hop aboard the latest trend. Joining me to talk about some of the latest trends is John Rekenthaler. He is the vice president of research for Morningstar.

John, thank you so much for being here.

John Rekenthaler: Indeed, Christine, pleasure.

Benz: John, let’s start with a category where we’ve seen a lot of investor interest. We’ve seen a lot of new exchange-traded funds launched to capitalize on the trend, and the idea is low-volatility stock investing. I’d like to get your take on whether you think this is a fad, a gimmick, or whether it’s an investment trend that actually has staying power.

Rekenthaler: First, just before we go, because we’re going to talk about a few of them, these are my views, but I think it can come across a little bit too glib like a movie critic, thumbs up, thumbs down. I’m going to be wrong on some of these. These are just my views. When I hear, this is based on past experience, but I will be wrong on one or two. I want to go at this with a little bit of humility because it sounds like I’m going to have views on everything. Because I have views doesn’t mean I’m right on everything.

Anyway, so if we start with low volatility, I’m suspicious of low-volatility funds because I remember something actually somewhat similar 20 years ago in the early 1990s. Utility funds and other low-volatility funds at the time had the best 10-year track records. They were not only the lowest in volatility. They had the highest returns. They were hogging the Morningstar 5-star ratings as well as any other risk-adjusted returns, and a lot of money flowed into them. And they got whacked in 1994 when interest rates rose.

Benz: The data look really good when you look at these low-volatility strategies, too, that the returns are better than higher-volatility strategies and, of course, risk is lower.

Rekenthaler: Right. The good news about these strategies is there is actually a fair amount of academic research behind them and some good people and some good firms, and they also have an economic argument as to why low-volatility strategies should outperform. It has to do with institutional constraints on leverage and so forth. So it’s not just data mining. I mean, there is also an economic explanation that has some good parties at this table. The timing feels bad to me. It feels like 20 years later. Interest had been dropping for a decade. That benefits these low-volatility investments which tend to be interest-rate-sensitive, and they got whacked when rates rose. Now we’ve had a 30-year period basically where rates have come down and maybe they’re starting to rise, and guess what, these strategies are being promoted. So the timing feels wrong to me. I think this is not the time I would be enthusiastic about them.

Benz: Let’s just walk through why would a low-volatility strategy necessarily be hurt in a rising-rate environment?

Rekenthaler: Well, these things tend to have higher-dividend, slower-growing companies, mature companies, so they act more like bonds. It’s less of a growth story. In some cases, when you get into the traditional utilities, they really are surrogate bonds.

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