FDLO - Fidelity Low Volatility Factor ETF: Unleashing The Power Of Low Volatility Stocks

2023-04-13 13:17:16 ET

Summary

• Intermarket behavior suggests that volatility and an associated accident in the markets look increasingly likely.
• A short squeeze in treasuries could kickstart another round of volatility.
• FDLO is pricey but offers some useful defensive qualities.

Uncertainty is an uncomfortable position, but certainty is an absurd one. - Voltaire

Introduction

The Fidelity Low Volatility Factor ETF ( FDLO ) is a ~$500m sized ETF that uses a proprietary methodology to identify large-and-mid-cap US stocks that exhibit lower volatility qualities than the broader markets. I feel a product of this ilk may come in handy while protecting one's portfolio during a period of great uncertainty. Here are a few reasons why I think FDLO may shine during times like these.

Why FDLO

If you've been following some of my commentary on Instagram or Twitter, you'd note that I posited that March could see a spike in volatility, which would carry on in April as well, where one was also likely to see a correction in risk assets.

I recognize that a lot of perma bulls would pay scant regard to my warnings, as traditionally, April, in a pre-election year, has rarely ever proved to be a month of wealth destruction. However, I feel that the melt-up seen this year is based on a lot of uneducated speculation, even as various inter-market signals continue to suggest that an accident could well be brewing.

Last week, in the macro section of The Lead-Lag Report, I noted how recently there were two previous instances where there was a deviation between the S&P 500's movements and the lumber/gold ratio. These deviations typically don't tend to last for too long, but as we speak the variance is now persisting for the fifth straight month with the lumber/gold ratio at multi-year lows. It looks increasingly likely that the deviation is unlikely to last for too long, and a correction in large-cap stocks could be just what the doctor ordered.

Much of the variance has been driven by unreasonable expectations of an impending dovish pivot by the Fed, but this has failed to come through, and when the market is forced to face the reality of a false signal you tend to witness some big hits in risk sentiment. Axel Merck, a portfolio manager recently also noted on my timeline that the Fed's unwillingness to be decisive one way or the other also was instrumental in causing volatility to spike.

Speaking of the Fed, I've also suggested that it could be instrumental in seeing the stress baton being passed on from regional banks to hedge funds, leading to yet another spike in volatility. How so? Well, for the uninitiated, speculative short bets by hedge funds on treasuries are at their highest point since 2018, as these guys think the Fed will keep tightening. Separately, also note that credit default swaps on US treasuries are now at their highest point in 10 years.

When that narrative flips, you could see a massive short squeeze on treasuries, causing havoc to the hedge fund industry. I'm not going to sit here and give brownie points to which side I think will win, but what's important to note is that these are all situations that are likely to keep volatility elevated in the broader markets.

In order to navigate choppy weather, it may be prudent to gain some exposure to a product with FDLO's characteristics. Firstly, as the name would suggest, FDLO has innately lower volatility qualities than the broader markets. This has been consistent across time, and currently, the 30-day rolling volatility variance is close to 300bps.

Secondly, over time, FDLO's sensitivity to the broader markets has only continued to trend lower offering some useful hedging qualities.

Finally, investors may want to consider the improving prospects of the ETF's expected Sortino ratio which is currently almost close to 2x. What this basically tells us is that during bouts of ample downside deviation, FDLO could be well placed to deliver excess returns of close to 2x.

Risks

For all the potential merits associated with pursuing a low-vol product during a difficult environment for risk assets, investors need to also recognize that access to these products doesn't come cheap. FDLO currently trades at a hefty forward P/E of 20x , around 8% higher than the S&P 500. Some of you may suggest that the variance isn't too troubling, but then again also do consider that the constituents of the benchmark index are expected to witness earnings growth of 16% (Source: YCharts), a good 600bps higher than what the constituents of FDLO look set to deliver.

The other risk to note is that FDLO's portfolio is dominated by the tech sector, a sector which appears to have a short-term bump. Subscribers who perused the "Leaders-Laggers" section of my research may tell you that after months of witnessing a relentless rise, the tech sector's strength relative to the S&P 500 appears to be fading off late.

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