Low Volatility Funds Prove Resilient

NEW YORK ( TheStreet) -- When the market crashed in 2008, it paid to own steady funds, such as American Century Equity Income ( TWEIX) and Vanguard Dividend Growth ( VDGIX). Holding reliable blue chips, the low-volatility funds lost less than their peers during the downturn. But in 2009, the Steady Eddies trailed as markets soared and investors preferred riskier stocks.

Now that markets have moved to firmer ground, should you dump the steady funds? Probably not. Researchers have shown that steady stocks deliver competitive returns while excelling in downturns. "It makes sense to have a low-volatility tilt in a portfolio," says Andrea Frazzini, vice president of money manager AQR Capital Management.

Frazzini says that many academic studies have looked at high-volatility stocks, which bounce around more than the overall market. The volatile stocks take plenty of risk, but they don't necessarily outperform low-volatility stocks over the long term.

Researchers offer a variety of explanations for why low-volatility stocks excel. One explanation is that many steady stocks are reliable blue chips, such as Exxon Mobil ( XOM) and Procter & Gamble ( PG).

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These familiar names are often considered dull, so their prices may remain modest. Because the prices are low, the long-term returns are relatively strong. In contrast, volatile stocks include glamorous technology and growth shares, which promise to deliver big earnings gains. However, because investors bid up the prices of volatile stocks, the long-term returns may be meager.

To add a low-volatility choice to your portfolio, consider First Eagle US Value ( FEVAX). Besides picking solid undervalued shares, the fund also reduces risk by holding some cash. That helped First Eagle outdo the S&P 500 by 14 percentage points during the downturn of 2008.

Limiting losses, the fund returned 6.3% annually during the past five years, outdoing 95% of peers in the large blend category, according to Morningstar. These days portfolio manager Abhay Deshpande is holding some gold as an insurance policy against market surprises. His stock holdings include rock-solid companies, such as Microsoft ( MSFT) and 3M ( MMM).

Another low-volatility fund that shined during the erratic markets of recent years is Amana Trust Income ( AMANX). Portfolio manager Nick Kaiser likes high-quality dividend-paying stocks, such as Illinois Tool Works ( ITW) and PepsiCo ( PEP). When markets look threatening, Kaiser can hold cash. During 2008, he kept as much as 30% of assets in cash. That enabled him to outdo 99% of his large blend peers for the year.

For a large value choice, consider Auxier Focus ( AUXFX). During the past five years, the fund returned 6.0% annually and outdid 97% of competitors. Portfolio manager Jeff Auxier looks for unloved stocks with high returns on equity. Holdings include Wal-Mart Stores ( WMT) and drug maker Abbott Laboratories ( ABT).

To get a pure dose of low-volatility stocks, consider some new ETFs, Russell 1000 Low Volatility ( LVOL) and PowerShares S&P 500 Low Volatility ( SPLV). While Russell uses a complicated formula to pick the stocks that have bounced around the least, the PowerShares fund follows a simple screen, taking the 100 stocks in the S&P 500 that have had the lowest volatility -- as measured by standard deviation -- for the past 12 months. Both ETFs hold such rock-solid blue chips as H.J. Heinz ( HNZ) and Chevron ( CVX).

If you trade in your S&P 500 funds for one of the low-volatility ETFs, will you sacrifice returns? Not necessarily, says Samuel Lee, a Morningstar analyst. Lee says that the low-volatility ETFs should about match the showing of the S&P 500 while taking less risk. "The ETFs should outperform the S&P 500 on a risk-adjusted basis," says Lee.

Besides offering solid returns, the low-volatility funds have other virtues. They tend to pay rich dividends. American Century Equity Income has a yield of 2.7%, while the PowerShares low-volatility fund has a yield of around 4%. In rough markets, the dividends could help to prop up returns and protect shareholders from the worst losses.
Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.

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