* Stock investors seek smoother ride after market gyrations
* Demand for low volatility European equity funds booms
* Strategy suits long-term buyers with "deep pockets" - BNP
By Francesco Canepa
LONDON, May 2 European investors nursing bruises from years of jittery equity markets are increasingly turning to shares that trade without wild swings to meet their need for steady returns.
Demand for European funds invested in shares offering low realised volatility - the rate at which a security's price moves up or down - has surged in the past year, funds data showed.
The assets of European exchange-traded funds (ETFs) adopting low-volatility, or minimum variance, equity strategies account for less than 1 percent of the European total but rose to $8 billion last year from $19 million in 2010, Markit data showed.
Money invested globally in ETFs tracking MSCI's low volatility indexes grew from less than $1 billion in 2010 to around $17 billion at the end of March 2013.
"Although equities are a sensible long-term investment, in the short term they are invariably uncomfortable," Greg Davies, head of behavioural investment philosophy at Barclays Wealth, said.
"Minimum variance strategies are a slightly safer, more comfortable means to get into the equity market."
Sharp stock market swings since 2000 have been a major factor in keeping long-term investors, including the $35 trillion global pension fund industry, away from equities.
This has led fund managers to develop strategies aimed at reducing equity swings, such as investing in the shares offering the lowest volatility.
"We see a lot of... insurance companies and pension funds that are looking at minimum variance," said Ossiam's Isabelle Bourcier, who manages the largest low-volatility ETF invested in European shares. She expects these strategies to account for 5 percent of Europe's ETFs within the next decade.
"These kinds of investors have largely been away from equity markets since the end of 2011. Now they're...returning to the equity markets because of the debt market being so low in terms of yield."
Bourcier's iSTOXX Europe Minimum Variance Index, which has outperformed the STOXX Europe 600 by 8.4 percentage points since its inception in 2011, picks liquid stocks with the lowest volatility and correlation with the broader market.
Telecoms group Swisscom, food maker Nestle and UK utility National Grid are the top three holdings in the fund, which is skewed towards defensive sectors.
The outperformance of defensive shares, which are less sensitive to the economic cycles and thus to market swings, has boosted low-volatility funds during the financial crisis.
However, this concentration on defensive sectors is the main catch in low-volatility strategies as it means they underperform market rallies led by shares linked to the economic cycle.
To tackle this problem, BNP Paribas's Equity World Low Volatility fund picks the least volatile stocks in each sector of the MSCI World index, including cyclicals.
The fund's total return was 4 percentage points higher than those of the MSCI World between 1995 and 2011, its launch year, while its volatility was lower, back-testing data showed.
It was the largest fund in a Lipper low-volatility European basket, which saw the biggest net inflow since 2008 in the last quarter of 2012 and has continued to rake in money.
"What's really new is that we see interest in this strategy from more mainstream investors," said Etienne Vincent, head of systematic portfolio management at BNP Paribas affiliate, THEM, who forecasts low-volatility funds will represent 10 percent of all European equity funds in the next decade.
A Reuters basket of the three stocks with the lowest 200-day volatility in each STOXX Europe 600 sector returned an average 19.7 percent in the past 12 months, outpacing a 15.8 percent index return. Only seven of the basket's constituents fell.
The basket consists mainly of UK, Swiss and Nordic listed shares. None of the 57 companies is Spanish and only one is Italian, the globally exposed pipe-maker Tendrils.
This shows a low-volatility filter tends to exclude stocks exposed to the most troubled economies.
But these strategies do not provide complete protection from equity selloff and lag major rallies.
"These strategies... can be subject to significant drawdown," THEAM's Vincent said. "You need deep pockets and a long-term investment horizon."