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.


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.



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