By John Wasik
CHICAGO, Feb 18 (Reuters) - With U.S. stocks doing a stutter-step after a five-year bull run, a shift into low-volatility funds might give you a little more traction if the market retrenches.
Low or "minimum" volatility funds have become more popular since the 2008 meltdown. Buying mostly defensive stocks with high dividends and modest price variations, they represent an $11 billion market for moderately risk-averse investors.
The most popular fund in this category, the PowerShares S&P 500 Low-Volatility ETF, holds more than $3 billion in assets. It owns brand-name stocks like McDonald's Corp and Johnson & Johnson, along with lesser-known companies like Sigma-Aldrich Corp.
The fund, which charges 0.25 percent for annual management expenses, was up 14 percent for the year ended Feb. 12.
A similar fund is the iShares MSCI USA Minimum Volatility ETF, which with slightly more than $2 billion in assets is a runner-up in terms of size in this group. It holds nearly half of its portfolio in consumer defensive, healthcare and financial services stocks like AT&T Inc, Wal-Mart Stores Inc and United Parcel Service Inc.
The fund charges slightly less in annual expenses - 0.15 percent - and gained about 16 percent in the year through Feb. 12. But both it and the PowerShares ETF are lagging the Standard & Poor's 500 stock index, which is up 22 percent for that period.
Although it is too early to tell, low-volatility funds might have a distinct advantage if the bull cycle has reached or surpassed its peak.
If corporate earnings falter or global economies slow, the market may tilt toward value and dividend-rich stocks.
To date, though, the low-volatility advantage has yet to appear. Both the S&P 500 and low-volatility shares are closely tracking each other, down slightly more than 1 percent year to date as of Feb. 12.
Despite the desire to time the top of a bull market, it is tough to make an exit from growth stocks into high-dividend shares. Market peaks are notoriously difficult to discern.
The most pressing question for a long-term investor is whether to tilt more toward value than growth. Until this year, growth stocks have had their run of the roost, but value may dominate if fear stalks the market.
It is typical for low-volatility funds to bulk up on boring, dividend-rich sectors like consumer durable, healthcare and utilities.
The PowerShares fund, for example, has nearly half of its portfolio in those three groups. Both it and the iShares fund have yields north of 2 percent, which reflect the higher payouts of those kinds of companies.
Yet what appears to be a virtue can be a disadvantage, particularly if the bull has room to run and the market will still favor growth stocks.
By their very staid nature, low-volatility funds may not outpace the S&P 500, which rose 32 percent last year with dividends reinvested, compared with 25 percent for the iShares fund.
Instead of trying to guess where the market is going and reacting week to week, a dividend-growth strategy might prove potent in the long run. The Vanguard Dividend Appreciation Index ETF, which I hold in my 401(k), lagged the S&P 500 by only about 1 percentage point over the past three years.
The Vanguard fund, which focuses on companies that consistently raise their dividends, is slightly more diversified than the other low-volatility funds I have mentioned. Its portfolio is more spread out among mega-, large- and medium-size companies with holdings like Abbott Laboratories, Procter & Gamble Co and PepsiCo Inc. It costs only 0.10 percent annually to own and was up 16 percent for the year ended Feb. 12.
Companies paying lower but growing dividends may also be bargains, Matt Freund, chief investment officer of USAA Funds in San Antonio, stated in a recent market commentary.
"Companies increasing their dividend payments are making a commitment to the market," Freund said. "They are telling investors that their business is strong enough to generate the free cash needed to pay higher dividends in the future."
Whatever path you take, do not confuse low-volatility funds with no volatility. All low-volatility stock funds will still react to market swoons. The Vanguard fund, for example, was down more than 3 percent year to date through Feb. 12, compared with a 1.3 percent decline for the S&P 500.
Concentrating too much on defensive stocks will certainly create a drag on performance if growth still dominates, but that may not be a bad thing if you want to focus on total return over the long haul.