Swedroe: Be Wary Of The Low Vol Factor

February 13, 2015

The superior performance of low-volatility stocks—the low-volatility anomaly—has been documented to exist in equity markets around the globe. And since its discovery, a good amount of academic research has attempted to determine both its origins and whether or not it will continue to persist.

Among that research is a December 2013 paper, “A Study of Low Volatility Portfolio Construction Methods.” The authors of the study concluded that the reduction in a portfolio’s volatility is driven by a substantial decrease in its market beta, and that low-volatility strategies outperformed their corresponding cap-weighted market indexes due to exposure to the value factor, the betting-against-beta (BAB) factor as well as the duration factor.

In other words, investors were trading one risk (beta) for two others (value and term). This conclusion is consistent with the findings of prior research.

It’s worth noting that this “trade” might be a good thing, as a tilting toward low-beta stocks diversifies the sources of risk and return away from the single factor of market beta. However, investors should be aware of the trade-offs they are making. Substituting one risk for others isn’t the free lunch that some have made low-volatility investing out to be.

Factor Fatigue

Unfortunately, as is the case with many anomalies, their discovery can often lead to their disappearance. In this case, investors should be concerned that the popularity of low-volatility stocks could cause them to become expensive, a development that may eliminate their performance advantage.

With that in mind, let’s take a look to see if the cash flows into low-volatility products have changed their very nature, reducing their exposures to the value effect (which explains much of their performance).

Examples To Study

We’ll examine the valuation metrics of the market’s two largest low-volatility ETFs, the PowerShares S&P 500 Low Volatility Portfolio (SPLV | A-48), with $5.8 billion in assets under management, and the iShares MSCI USA Minimum Volatility ETF (USMV | A-67), with $4.5 billion in AUM.

We’ll then compare them with the metrics of the iShares Russell 1000 ETF (IWB | A-93), which is a market-oriented fund, and the iShares Russell 1000 Value ETF (IWD | A-88). The table below is based on Morningstar data as of Feb. 11.

 

  SPLV USMV IWB IWD
Price-to-Earnings 19.3 20.3 17.5 16.1
Price-to-Book 2.4 3.1 2.4 1.7
Price-to-Sales 1.7 1.6 1.6 1.3
Price-to-Cash Flow 9.2 8.9 10 8.8

 

As you can see, the two low-volatility ETFs no longer look anything like value-oriented funds. Not only are each of the funds’ price–to-value metrics higher than the value-oriented IWD, they also tend to be higher than or near the market, like IWB.

 

Shifting Strategy

Framed another way, the popularity of the strategies, leading to large cash flows, has turned the low-volatility strategy into more of a growth-oriented strategy. In addition, the higher-than-market valuations also predict below-market future returns. If that occurs, the low-volatility anomaly will have “gone with the wind.”

There’s another issue that should concern those investing in low-volatility strategies—their exposure to term risk. The fact that low-volatility strategies have exposure to term risk (the duration factor) shouldn’t be a surprise.

Generally speaking, low-beta stocks are more “bondlike.” They are also typically large stocks, low-volatility stocks, stocks of profitable and dividend-paying firms, and stocks of firms with mediocre growth opportunities. In other words, they are stocks with the characteristics of safety as opposed to risk and opportunity. Thus, they show higher correlations with long-term bond returns.

Ronnie Shah, author of the study “Understanding Low Volatility Strategies: Minimum Variance,” found that for the period from 1973 through 2011, the low-beta strategy had exposure to term risk. The “loading factor” (degree of exposure) was 0.09, and it had a statistically significant t-stat of 2.6.

As further evidence, the authors of the previously mentioned study, “A Study of Low Volatility Portfolio Construction Methods,” found a 0.2 correlation between the BAB and duration factors.

Fixed-Income Substitution

Because of their bond-like traits, many investors use low-volatility (and high-yielding) stocks as fixed-income substitutes. These high-yielding, low-volatility stocks have been bid up by investors seeking yield and relative safety amid the very-low-rate environment we have experienced for the past six years.

And the possibility, if not the probability, of interest rates rising from their current historically low levels creates the potential for duration risk to further detract from forward low-volatility performance, instead of helping it along as it has in the past.

We can also see how the increased popularity of the low-volatility strategies has changed their very nature by examining how the loading factors have shifted over time.

Value Or Growth?

We’ll take a look at the results of a regression analysis on SPLV and USMV. Using the tool provided by this website, we’ll begin with a look at SPLV. The inception date of this ETF was May 5, 2011. And data is available through October 2014. We’ll split the 41-month period into two roughly equal halves, June 2011 through February 2013; and March 2013 through October 2014.

The regressions include the beta, size, value, momentum, quality and low-beta factors, as wells as the two bond factors of term and default. In the first half of the period, SPLV had a loading on the value factor of 0.78. For the second half of the period, the value loading was -0.07. In other words, SPLV went from having a very high loading on the value factor to now having a slight loading on growth.

The inception date for USMV was Oct. 18, 2011. Thus, we’ll split the 36-month period into two equal 18-month periods, November 2011 through April 2013; and May 2013 through October 2014. For the first half of the period, the value loading was 0.56. In the second half, it was -0.29.

Once again we see the same result. The very nature of the fund has shifted from value-oriented toward growth-oriented. And the results of the regression analyses confirm what a simple look at the valuation metrics told us.

Lower Expected Returns

There’s a cliche in finance that success can sow the seeds of its own destruction. At the very least, investors in low-volatility strategies should be aware that the flow of cash into the strategy has changed the very nature of the funds. While they may still be low volatility, they no longer look like value funds.

And the lower exposure to the value premium means they now have lower expected returns. In addition, it doesn’t seem likely that low-volatility strategies will benefit in the future as they have in the past from their exposure to term risk.

The bottom line is this: Forewarned is forearmed.


Larry Swedroe is the director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.

 

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