(Bloomberg) — Friday's U.S. stock rout, the worst since Britain voted to leave the European Union, spared few investors, particularly not owners of ETFs designed to minimize turbulence.
Low-beta ETFs plunged even more than the broader market, extending a move that began two days earlier. The PowerShares S&P 500 Low Volatility portfolio slid almost 3% on Friday and the iShares Edge MSCI Min Vol USA ETF fell 2.7%, the worst daily losses in more than a year. Meanwhile, the S&P 500 dropped 2.5%.
While a few days say nothing about the ETFs' viability as low-volatility surrogates, the declines illustrate what some say are distortions in a market that has been dominated by defensive shares. Not only have industries that make up the low-vol universe gotten expensive, many of them are extra sensitive to rising bond yields.
"High-dividend and low-growth stocks have traditionally not been very volatile, sort of by definition, because there's not much growth, there's less uncertainty about what it should be worth," said Pravit Chintawongvanich, head derivatives strategist at Macro Risk Advisors in New York. "The value is just driven by what they pay out as dividend."
Tranquility that had enveloped global markets for more than two months was pierced Friday as central banks started to question the benefits of further monetary easing. The S&P 500 Index tumbled 2.5%, erasing about $500 billion of market value.
In low-volatility funds, the trigger for the selloff was hidden in a different asset class altogether — Treasuries, where yields on 10-year notes jumped to the highest since June. After reaching record lows earlier this year, bond yields have been shooting up amid speculation that central-bank support may end sooner than previously anticipated. That's taking a toll on the low-volatility category, which is dominated by companies whose dividends become less competitive as bond payouts rise.
How big a drag are bond rates on the ETFs? The extent can be seen in a PowerShares ETF that mimics the low-volatility cohort but kicks out stocks that have been historically sensitive to rising yields. On Friday, that fund fell 2%, compared to the 3% decline in the S&P 500 Low Volatility fund.
Reynolds American, who's reliable dividend and place in the consumer-staples group make it a popular low-vol bet, fell 5.4% on Friday, it's biggest drop since July 2014. American Tower and Sysco, two other dividend-paying companies in the PowerShares low-vol ETF, fell more than 5.2%, both sliding the most since 2013.
"If you're looking at low volatility, one of its characteristics is it can be sensitive to the direction of interest rates," said Nick Kalivas, senior product strategist at Invesco's PowerShares ETF unit in Downers Grove, Illinois. "Generally speaking, if you see rates start to trend higher, low-vol at least at the initial stages shows underperformance."
The ETFs have been a goldmine for fund providers in 2016. Mostly due to inflows to Invesco's PowerShares and BlackRock's iShares franchises, funds aimed at muting swings have seen their market value jump this year by about $1.5 billion and $7 billion, respectively.
One consequence has been that the shares that make up the underlying indexes are getting more expensive, something that in isolation makes them more turbulent. The one-month realized volatility of both the PowerShares and iShares low-vol funds currently sit above that of the S&P 500.
Because the funds rebalance, stocks which act more volatile as interest rates rise will eventually be swapped out. The bigger danger is ballooning valuations, said Chintawongvanich. Defensive sectors like utilities and consumer staples have price-earnings ratios more than 16% about their 10-year average. Indeed, the fortunes of low-volatility ETFs have also started to align with stocks that have the highest price momentum, according to Bloomberg's portfolio analytics tool.
"The inflows have driven up the valuation of these stocks, potentially making them overvalued relative to what they should actually be worth and how much they can grow," Chintawongvanich said. "The only thing that really kills the case for low-vol is too many people in it."