Some Investors Tried to Win by Losing Less. They Lost Anyway.

An investment strategy for reducing risk in the long run has raised it in the short run.

Funds holding stocks that fluctuate less than the market as a whole are supposed to do better in bad times while still faring well in good times. Their performance in 2020 has been perverse: Several lost at least as much as the market in February and March, but later lagged far behind when stocks shot up more than 50%.

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The low-risk funds put old lessons in high relief: Historical returns often paint a distorted picture, rigid rules have unintended consequences and the market loves to make monkeys out of people who think they've solved it.

Investors added $36.5 billion to these exchange-traded funds from 2017 through 2019, according to FactSet, with $22.3 billion pouring in last year. The biggest: the tonguetwister-ish iShares MSCI USA Min Vol Factor ETF, at $34.6 billion in assets, and Invesco S&P 500 Low Volatility ETF, with $8.8 billion.

Yet, over the past year, seven of 19 such funds tracked by FactSet have fluctuated even more sharply in down markets than their benchmarks. Almost all have bounced around at least 85% as much as their market averages.

These funds are a contrarian play on the market, bucking the traditional belief that stocks with higher risk should generate higher returns in the long run.

Here, investors aren't seeking to maximize short-term gains, but to minimize the risk of loss.

Owning low-risk stocks is like "going to a party and standing there with your soda while everybody else is drinking liquor and jumping up on the tables to dance," says Pim van Vliet, a quantitative portfolio manager at Robeco Institutional Asset Management B.V. in Rotterdam, the Netherlands.

Nobody likes being "the boring guy," says Mr. van Vliet. But, in theory, this can provide an opening. Other investors pursuing the excitement of short-term gains undervalue low-risk stocks, enabling them to deliver superior returns in the long run.

Yet this theory can be difficult to translate to the real world.

Often, the "backtests," or hypothetical historical results used to market such funds, are based not on one portfolio, but two. Researchers assume an investor bought the best stocks identified by the strategy and sold short, or bet against, the worst.

The simulated past results also often assume you put an equal amount of money in each stock rather than more in the biggest. And they usually pretend that trading has always been free.

In the real world, where regulations restrict funds from extensive short selling, these portfolios can profit only by betting on winners, not by betting against losers. They also incur trading costs, which can be substantial at big funds.

In practice, ETFs investing in low-risk stocks have bulked up in such historically stable areas as financials, electric utilities and real estate.

Early this year, those three industries were 12%, 4% and 3%, respectively, of the S&P 500's market value.

So funds like these were making massively different bets than the market.

With such approaches, "the key underlying assumption was that what happened before would be reflective of what was coming," says Arik Ben Dor, head of quantitative equity research at Barclays in New York. "But what happens when this is no longer the case?"

When the pandemic struck, industries that could operate remotely or address the health crisis—software or biotechnology, for example—suddenly seemed safe. Financial and real-estate stocks tanked as credit markets seized up and tenants couldn't pay their rent, while utilities' share prices flickered wildly as investors worried that demand would collapse.

The low-risk funds are run according to rules, not human judgment. When share prices shatter, the funds generally can't delete those with the wildest swings and immediately replace them with smoother alternatives. Instead, the funds tend to make changes on a predetermined schedule—which, in 2020, just so happened to fall at the worst possible time for some.

The Invesco fund, for instance, adjusts its holdings four times a year. On Feb. 21, early in the market decline, the fund could make only a few tweaks, because its rules required it to measure stock fluctuations over the full year through Jan. 31—the calm before the storm.

On the fund's next rebalancing date, May 15, the rules required it to measure changes over the 12 months ending Apr. 30—so the chaos of February and March was suddenly a large part of the calculus.

In one swoop, the fund changed 64 of its 100 holdings, says Nick Kalivas, a senior ETF strategist at Invesco. Its exposure to health-care stocks jumped from roughly 5% to 26%. Utilities fell from 27% to less than 6%; real estate, from 15% to 2%.

But, like its peers, the Invesco fund remained underexposed to the technology stocks that have led the subsequent rally.

Holly Framsted, a managing director at BlackRock Inc., which manages the iShares ETFs, says the firm remains confident the low-risk approach can still work well.

"Over the long run, minimum-volatility strategies have tended to deliver about 80% of the risk in the market," she says. "That doesn't mean that they will lose less in every single downturn, because these are not insurance products. But, over time, you should experience a smoother ride and win more by losing less."

In months when the S&P 500 has fallen by at least 5%, says Ms. Framsted, the strategy has lost an average of 2.5 percentage points less. From the end of 2015 through mid-February 2016, when the S&P 500 fell 12%, leading low-risk funds lost half as much, according to Barclays.

Managers say these funds aren't meant to be an investor's sole or largest exposure to stocks, but rather one part of a diversified approach.

However, Elisabeth Kashner, director of ETF research at FactSet, says such funds often have been promoted as sweeping solutions. "When a product is sold with the implication that it's going to deliver risk-adjusted outperformance," she says, "what would it dislodge other than core portfolio holdings?"

It isn't a mistake to try lowering your risk. It is a mistake, however, to assume that the future will resemble the past, that rules are infallible and that you should dive into any one strategy with both feet.

Write to Jason Zweig at intelligentinvestor@wsj.com