Personal Finance

Once considered safe, ‘smart’ funds may be dumb investment

Gail Marks Jarvis is a personal finance columnist for the Chicago Tribune.
Gail Marks Jarvis is a personal finance columnist for the Chicago Tribune. MCT

Who could resist investments that are “smart”? They certainly sound better than “dumb investments” or “idiotic funds.”

And who wouldn’t want to cut “volatility” in their investments? In other words, who wouldn’t want protection from a stock market crash such as those in 2000 and 2008, which turned 401(k)s into 201(k)s as stocks plunged more than 50 percent.

Fund company professionals who create mutual funds and exchange traded funds (ETFs) realized after those horrible crashes traumatized people that if a fund could promise to take some of the pain of volatility away, their companies would have a hot investment product. And indeed they do.

Since 2008, investment companies have been churning out different forms of funds known as “smart beta,” and there’s now more than $500 billion in them. They are known as low- or minimum-volatility funds, designed to hold stocks that are less likely to crash as severely than the stock market as a whole.

The concept sells. Investors are drawn to them at a time when CD and bond interest rates are minuscule, and memories of those stock market crashes still keep people awake at night.

Instead of fast-growing stocks such as Amazon or Tesla, the low-volatility funds tend to pick blue chip companies, known for their stable profits and performance – companies such as AT&T and Johnson & Johnson. The idea is that in a recession, consumers might not shop for a new tech gadget, but they will still buy toothpaste, diapers and laundry detergent.

The trouble is that whenever any investment becomes ultra popular – even a stable company – it ultimately will become risky if people like it too much. And that was a common warning from investing pros who spoke this week at the annual Morningstar ETF Conference in Chicago.

Repeatedly, analysts mentioned that the dividend-paying stocks that make up low-volatility funds have been attracting so much money from risk-averse people lately that demand has pushed the stock prices way up. And when stocks or funds get too pricey, they can fall and fall hard. That realization has made some investors leery of the popular sectors that are favorites in low-volatility funds: utilities, real estate investment trusts (REITs) and consumer staples such as Procter & Gamble.

But so far, the uptrend remains. During the first seven months of this year, one of the most popular low-volatility funds – the iShares Edge MSCI Minimum Volatility USA (USMV) fund – delivered a 13.26 percent gain. That’s huge compared with less than 8 percent in a Standard & Poor’s 500 index fund.

Instead of being lulled by the gain, however, Morningstar analyst Ben Johnson has warned that an examination of data back to 1994 shows that when the MSCI USA Minimum Volatility Index has been pricey, there have been declines. And he noted that at the end of July, the index was the priciest since its launch in June 2008.

Analysts also point out that the low volatility approach could be vulnerable if the Federal Reserve starts raising interest rates this month or in December. If interest rates start climbing, people who bought utilities and REITs for dividend income while interest rates were remarkably low will see safer alternatives for their money. They may sell utilities and REITs, as they have in the past when interest rates headed up, and put money into bonds and CDs instead. If the utilities, REITs and other dividend-payers in low-volatility funds are heavily sold, the low-volatility fund values also will decline.

Because low-volatility funds are relatively new, they have not been tested during a period of rising interest rates – the type of period that may be coming in the months ahead.

So people could become unnerved if they bought low-volatility funds thinking the funds would always be a defense against stock market losses. Like every type of investment, low-volatility stocks ride cycles and will go up and down. But most investors don’t give funds a chance when they act differently than assumed.

Jason Hsu, chairman of Rayliant Global Advisors, told a Morningstar audience that humans have a lousy track record with funds: “They add onto what they’ve heard others say made great money.” Then, the cycle turns and “they sell and cause themselves great harm.”

Gail MarksJarvis is a personal finance columnist for the Chicago Tribune and author of “Saving for Retirement Without Living Like a Pauper or Winning the Lottery.” Readers may send her email at