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Why Are Low-Volatility Funds Witnessing Higher Instability?

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Low-volatility funds more volatile than SPY

Low-volatility funds generally have higher exposure to stocks that are insulated from large swings in the broader markets. The PowerShares S&P 500 Low Volatility ETF (SPLV) holds 23% in US utilities, which experienced notably higher volatility after the Federal Reserve’s hawkish commentary. The Fed’s statements caused Treasuries to surge. SPLV has lost 3% in the last month, underperforming the SPDR S&P 500 ETF Trust (SPY).

The graph below shows increased volatility in SPLV and XLU in the last couple of months, surpassing that of broader markets.

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Interest rate sensitivity and valuations

High dividend–paying companies are comparatively slow growing, making them relatively stable given their lower level of uncertainty. In the last eight to ten months, investors took shelter in such companies against turmoil in the broader markets.

Utilities, the sector that rallied the most, surged more than 20% in the first half of the year. The steep rally resulted in record valuation of utility stocks (XLU), which made them extra-sensitive to the Fed’s hawkishness.

Utilities, which historically traded near their five-year average EV-to-EBITDA[1. enterprise value to earnings before interest, tax, depreciation, and amortization] valuation multiple of 8x–9x, are currently trading above 11x. Their price-to-earnings ratios have not fallen below the 20x mark this year, which is well above their valuation multiple range of 15x–16x.

The S&P 500 Low Volatility Index is trading at a valuation multiple of 20x, which is in line with broader equities. Largely due to such towering valuations, low-volatility funds have corrected more than the broader markets.

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