A rush into less-volatile stocks has pushed up their prices

Journal Report

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But followers of this strategy may be buying the right funds at the wrong time. Investors may be overpaying for that perceived safety, and as a result, taking on more risk than they realize.

This flies in the face of the conventional wisdom that earning higher returns requires taking higher risk, but it’s music to the ears of investors who are still nervous about taking on big risks in the wake of the financial crisis.

ENLARGE

The Wall Street Journal

Just two years after it opened for business, PowerShares S&P 500 Low Volatility has $4.7 billion in assets, and iShares MSCI USA Minimum Volatility Index. which launched in October 2011, holds $3.9 billion. International low-volatility funds have also been gaining favor.

Over the past year, the PowerShares portfolio is up 20.1%, the iShares ETF is up 19.8% and the Standard & Poor’s 500-stock index is up 27.3%.

Michael Jones, chief investment officer at RiverFront Investment Group LLC, which oversees $3.8 billion in portfolios constructed with ETFs, says it’s clear why low-volatility portfolios have an appeal: The approach they use is a good deal in a normal market over the long run.

But, he adds, everything is a matter of price. Lately, investors have been bidding up the prices of defensive stocks, not just because of their safety but because the Federal Reserve’s aggressive easing moves have made their dividends especially attractive.

As a result, valuations in the group have gotten rich. The average price-to-earnings ratio of stocks in the low-volatility PowerShares S&P 500 ETF is 17.6 times projected earnings, according to Morningstar Inc. and it’s 17.4 for the iShares low-volatility U.S.-stock ETF. Those compare with a 14.6 forward P/E on the S&P 500.

Riverfront estimates that low-volatility stocks as a group are 30% to 40% overvalued.

That, says Mr. Jones, means returns for people buying now will be depressed relative to what the long-run potential could be. If the price I’m paying today is too high, I’m not going to do as well as I expect, he says.

Instead, investors should be looking in the opposite direction, toward stocks that tend to have higher volatility, says Mr. Jones. That means funds focused on technology stocks, financials and materials companies.

These stocks may not offer as much in the way of yield but provide the opportunity for earnings growth. And because investors have been wary of these kinds of stocks, valuations are much more reasonable, says Mr. Jones.

Where people are afraid, that is where the opportunities are, he says.

Send questions and comments to Mr. Lauricella at tom.lauricella@wsj.com .