Measuring Interest-Rate Sensitivity In Low-Volatility Stocks: Difficult Exercise!

Updated: Nov 11, 2019

The SPLV and low-volatility ETFs aren’t often added to investment portfolios because fund managers are incentivized by bonuses and additional fees if their strategies beat the market. Yet, that isn’t the case with a massive annualized underperformance of more than 3% in the long run. The most aggressive stocks (commodities, cyclicals, banks) that carry more risk don't produce higher returns, in fact, they underperform their benchmark more than the alpha generated by their lowest-volatility counterparts.


Low-volatility stocks provide us with quality, predictable cash flows, clear growth trajectory, perfect management execution, smaller drawdowns and smaller rallies. The SPLV has performed beautifully over the past two years and the question becomes: ‘Will it continue to do so?’

Research has indicated that its streak of outperformance can last really long (for over 6 years during the 80s). The main takeaway - in my opinion – is that during excessive optimism, the SPLV will lag the SPY but doesn’t drop significantly when the bubble bursts.

Also, it’s far more interesting to look at the drawdowns relative to the recovery time. Low-volatility stocks tend to fall less when markets sell off as their cash flows provide income investors with a nice dividend cushion (such as the invincible Dividend Aristocrats). The demand for those safe haven assets and their juicy dividend yields relies on the price action in the bond market. It’s difficult to find out the relationship between interest rates and the SPLV, but there’s definitely a moderately positive correlation, however, it’s rocket science considering today’s economic environment and the fact that investors are yield-starving pushing the valuation multiples for certain rock-solid companies to even loftier levels.

Let’s consider Next Era Energy, SBA Communications, the SPLV itself, Renaissance Holdings (insurance company) and Waste Management for a moment. Especially last year, long-term interest rates were higher than today and ticked higher during the first two months of the fourth quarter of last year while stocks sold off along with bonds. Despite higher bond yields, some utilities including NEE and the SPLV in general hit new all-time highs. Initially, the SPLV went down but its positive correlation with the declining bond market diminished every day resulting in significant outperformance relative to the SPY and TLT tracker. That’s remarkable given the SPLV's status of being rate-sensitive.


On the other hand, especially this year, some insurance companies (which are negatively correlated to the bond market, but less than what traditional banks like JPM are) didn’t suffer from the declining interest rates, neither did they sell off when bonds took a deep dive. The same goes for some REITs which don’t necessarily suffer from higher interest rates as their cash flows are narrowly based on the inflation rate.


Selling premium and implementing delta-neutral strategies reduced your portfolio volatility and your profit potential when markets rally or tumble. This is why selecting different non-correlated positions while looking at their relationship with interest rates is critical to successful option selling. By focusing on high-quality stocks, we opt for fewer drawdowns, shorter recovery times and steadily increasing share prices and all of these aspects make them perfect for our strategy.

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