New York

Banks are probably near the bottom of the list of stocks that come to mind when thinking of low-volatility shares. That appears to be changing, which Wells Fargo equity strategist Chris Harvey says may help boost their prices.

Twelve-month realised volatility, a measure some quantitative portfolios use to select stocks, has narrowed for the group in the past year, Harvey wrote in a note. Diminishing swings may qualify more of them for low-volatility exchange-traded funds, a big pool of money, he said.

“We and our large cap bank analyst, Mike Mayo, see less risk in banks’ underlying fundamentals, but the market has been slow in recognising the group’s changing risk profile,” Harvey wrote.

Products that aim to hold securities with smaller price swings have swelled, and inclusion of banks could expand the investor base. For instance, the iShares Edge MSCI Min Vol USA exchange-traded fund has a market cap of more than $26 billion, while Invesco’s S&P 500 Low Volatility ETF has about $11 billion. Both saw shares outstanding rise since the fourth quarter last year.

So far, uptake of bank stocks in the low-volatility funds has been slow. In the Invesco ETF, diversified financial services make up just 4.9 per cent, data compiled by Bloomberg show. But that’s up from nothing in 2016, Harvey said.

“There will be a larger and larger component of banks in that low-volatility bucket,” he said.

And while price swings in bank stocks remain elevated versus the rest of the market, they’re a lot calmer than they used to be. In the 10 years since the global financial crisis, banks have become subject to stress tests from the Federal Reserve. The Volcker Rule imposed restrictions on activities like hedging and proprietary trading. And credit profiles in the sector have gotten much more conservative.

“It’s actually forced these companies into a place many people wouldn’t expect them to be,” Harvey said in an interview.

Financial shares have been moderate performers this year, with the S&P 500 Banks Index gaining 12 per cent, 14th among 24 industry groups. They’re still unloved by hedge funds — they were the second-most underweight of the 11 major sectors behind consumer staples in the first quarter, according to Goldman Sachs Group Inc., which compared sector tilts versus the Russell 3000 Index in a May 20 report.

Mayo has been banging the underappreciated-bank-stocks drum for quite some time. At the 10th anniversary of Lehman Brothers Holdings Inc.’s collapse, Mayo said the ensuing decade had marked a U-turn for banks in everything from capital and cost control to aligning executive compensation with shareholder returns. The end result was the lowest earnings volatility in a generation, he said.

So if the banks do start to fit better into the low-volatility category, that could be a case for more optimism.

“Our evidence suggests large-cap banks will remain less risky, and the group’s presence in low-volatility funds should continue to expand,” Harvey said in the note. “Therefore, we expect relative upside and potential multiple expansion for the low vol banks over the coming months and quarters.”