Valuation only seems to work at extreme moments—such as the 1999/2000 Internet bubble or the aftermath of the 2008 global financial crisis—but factor timing also presumes that, by using valuation spreads, one can consistently predict when such extreme scenarios will materialize.
Of course, trying to time these types of crashes is as difficult as trying to time a market crash itself. Larry Swedroe on ETF.com also summarized recent academic work questioning the use of valuation as a factor-timing tool. Asness does not rule out the possibility of formulating a factor-timing strategy, and based on my own experience of testing quantitative factor timing strategies, I believe there is the potential to incorporate other metrics in factor timing such as trend-following rules and warnings signs indicating overcrowdedness, such as short interest levels.
However, even if a holy grail of factor timing could be uncovered, Asness makes this astute point:
" … unless we one day see these [factor] strategies also richen to unprecedented unsupportable levels, not something we see today, I see this as an unfortunate pain we must bear in exchange for the long-term positives of good factors. Again I make the analogy to knowing that the stock market will one day suffer a short painful 'crash' does not mean one doesn't invest in stocks for the long run."
Know What You're Buying
Despite Zweig's warning with respect to the valuation premium that low-volatility funds are trading at versus the broader markets (when historically they've traded at a discount), investors view low-volatility style as one of the better ways of maintaining market exposure without engaging in market timing.
The two most popular low-volatility ETFs are the iShares MSCI USA Minimum Volatility (USMV | A-69) and the PowerShares S&P 500 Low Volatility (SPLV | A-58), although some of the recent proliferation of multifactor ETFs such as the Goldman Sachs ActiveBeta U.S. Large Cap Equity (GSLC) incorporate a low-volatility factor.
Table 2 displays a characteristic breakdown between USMV, SPLV and the S&P 500 Index, as proxied by the SPDR S&P 500 ETF Trust (SPY | A-97). Table 3 displays the relative sector weighting differences of USMV and SPLV versus the S&P 500. All characteristic data comes from Bloomberg.
Table 2: Fund Characteristics
Table 3: Relative Sector Weights (vs. S&P 500 Index)
Based on the fund characteristics, we can observe the following:
- Low volatility trades at a premium to the S&P 500 on a forward-earnings and book-value basis.
- Low volatility also has a higher projected dividend yield, suggesting it is more susceptible to interest-rate movements (as implied in the WSJ article), although not as sensitive as pure dividend-focused ETFs.
- Based on sector deviations, one can argue that SPLV represents a purer play on low-volatility than USMV, since the latter constrains its relative sector deviations to 5%. However, with higher exposure to low volatility comes greater sector risk, as SPLV is much more concentrated in consumer staples and utilities versus USMV.
Running USMV and SPLV through Bloomberg's risk model, we find the following: