This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article features Benjamin Lavine, co-chief investment officer for 3D/L Capital Management in Hartford, Connecticut.
As equity markets, corporate credit, commodities and cryptocurrencies reach new post-pandemic highs amid prospects for global economic reflation, low volatility style of investing seems to have been left by the wayside.
Regardless of whether we’re seeing a shift from large caps to small caps and from “growth” to “value,” as long as the style in question captures higher beta (or higher risk stocks), then it seems to matter little. No one talks much these days about low vol, or funds such as iShares MSCI USA Min Vol Factor ETF (USMV) and the Invesco S&P 500 Low Volatility ETF (SPLV).
Be it record issuance of SPACs, or the outperformance of negative earning companies versus positive earners, or the frenzy around retail trading on platforms offering near limitless margin to trade call options and illiquid OTC stocks, the disdain for volatility protection can be summed up by Figure 1.
It displays the cost of an equity index collar or the premiums paid for index put options versus call options, which have reached multidecade low levels.
Figure 1: Gaga For Call Options As The Cost Of Equity Index Collars Reaches Multidecade Lows
Source: BofA Global Research via The Daily Shot
‘From 2016 Darlings To 2021 Duds’
The appetite for lower volatility strategies seems to have sunk down a memory hole along with August “Volmageddon” of 2019 (noted in “The Year Smart Beta Died?”) and the Brexit vote of June 2016, both periods of time where low volatility experienced significant outperformance only to revert once the market “crisis” at the time had passed.
Who wants lower volatility when the path for higher returns has been made clear by an overly accommodative Federal Reserve willing to keep rates near zero through 2023, and by the Federal government’s upcoming $1.9 trillion stimulus plan?
In addition, lower volatility strategies tend to underperform during a period of rising interest rates, as we noted back in 2017 (“Min Vol ETFs Underperform When Rates Rise”).
We’re not suggesting that low volatility investing is merely an investment fad that has turned from a 2016 Brexit-driven darling to 2021 post-pandemic dud. Low volatility has plenty of academic research documenting the anomaly when seen through risk-adjusted performance. Yet you probably won’t hear much of it discussed in the current market environment.
Low volatility’s unpopularity can be seen through a risk model lens where the “factor loadings” to U.S. momentum are at multiyear negative levels (seen in Figures 2 and 3 for both Minimum Volatility, which captures low risk and low cross-correlations, and Low Volatility, which are pure low risk stocks, as captured by USMV and SPLV, respectively.)
In these tables, we display the estimated sensitivity to various U.S. risk factors as defined by the Bloomberg U.S. Risk Model, with green representing the highest sensitivity and red the lowest sensitivity for each factor across the five-year period starting in March 2016. We highlight two specific periods: Current (2/15/2021) and the height of Brexit fears (6/30/2016).
Figure 2: The Unpopularity Of Minimum Volatility Investing As Seen Through A Risk Factor Lens (USMV)
Figure 3: The Unpopularity Of Low Volatility Investing As Seen Through A Risk Factor Lens (SPLV)
The Quality & Value In Low Vol
We also show the factor loadings to both “Value” and “Profitability” suggest that the fundamentals for Low Volatility look attractive on both a valuation and quality basis relative to recent history.
Finally, we display the sensitivity to “Volatility” itself where the current period demonstrates just how low “Low Volatility” has gotten. Low volatility may be out of favor, but it still reflects a higher quality investment style with one of the lowest risk profiles versus recent history.
The current risk profile of low volatility investing appears almost too good to be true. One would be investing against the tidal appetite for high-risk reflationary assets, but low volatility is priced for peak euphoria rather than peak panic.
At the time of this writing, 3D held positions in USMV and SPLV. The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future. It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy. It is for informational purposes only. The above statistics, data, anecdotes, and opinions of others are assumed to be true and accurate; however, 3D/L Capital Management does not warrant the accuracy of any of these. There is also no assurance that any of the above are all inclusive or complete.
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