Jason Zweig, writing in the Wall Street Journal, recently published a well-balanced article on low-volatility investing (The High Price of 'Low Volatility' Funds).
The article mainly serves as a cautionary tale for investing in the latest fads; in this case, the popularity of the low-volatility style of investing given its strong risk-adjusted outperformance over broad equities. However, the piece endeavors to represent the views of low-volatility advocates and their rationales for why this strategy makes sense.
Zweig's primary concern is similar to the one voiced by Research Affiliates: Low-volatility investing's popularity has pushed its historical valuation to unprecedented levels relative to both its own history and to the broader markets, leaving investors vulnerable to future disappointments.
Valuation Can Be A Poor Predictor
Indeed, Research Affiliates (RA) warned of the dangers of low-volatility investing as far back as the third quarter of 2013. Using valuation data through May 2013, RA contended that "low-vol strategies" had been trading at valuations well above their prior 10-year history as well as above the full sample period.
However, despite the danger signs flagged by RA, low-volatility investing continued to deliver competitive risk-adjusted returns versus the broader market (Table 1).
And despite trading at historically high valuations, low-volatility strategies delivered on their primary desirable attribute; namely, lower volatility (standard deviation) versus the broader markets.
Table 1: Low-Volatility Investing Delivers on Lower Volatility
*Data source: Bloomberg. Annualized returns and standard deviations based on monthly returns of indices representing styles covering market capitalization-weighting, low-volatility weighting (based on MSCI and S&P's methodologies) and fundamental weighting (FTSE RAFI Indices). For a larger view, please click on the image above.
In response to publications calling into question the "valuations" of alternative beta strategies, such as low-volatility investing, Cliff Asness of AQR Capital Management published an editorial piece in a forthcoming issue of the Journal of Portfolio Management titled "The Siren Song of Factor Timing."
The article questions the forecasting ability of valuation-based spreads (e.g., book-to-price spreads between the highest-ranked versus lowest-ranked securities) within a factor to determine future factor profitability.