Adding In Profitability
Novy-Marx found that by including profitability as a factor, the performance of the defensive (low-volatility) strategy is well explained by controlling for the common factors of size, profitability and relative valuations. Novy-Marx also found that defensive strategies tilt strongly toward large stocks (they are 30 times as large at the end of his sample, and the long-short portfolio has a size factor loading of -1.12), value stocks (the long-short portfolio has a value loading of 0.42) and profitable stocks.
The profitability tilt obscures the extent to which defensive strategies tilt toward value, because value and profitability tend to be strongly negatively correlated. Unless you control for profitability, the value loadings of defensive strategies will be lowered (an important insight).
Novy-Marx also found that five-sixths of the Fama-French three-factor alpha (57 out of 68 basis points per month) was delivered through the aggressive stocks on the short side of the strategy with only one-sixth, or 12 basis points per month, coming from the actual defensive stocks. And he found similar results when looking at a low-beta strategy.
A second important consideration is that, while the low-volatility factor may well be somewhat unique, and in the past it has provided a premium, the dramatic inflows into the strategy have altered the very nature of the strategy’s valuation characteristics.
Have Low-Volatility Strategies Become Overgrazed?
As is the case with so many well-known anomalies and factors, the problem of potential overgrazing does exist. Findings regarding the premium, combined with the bear market caused by the financial crisis of 2008, led to the aforementioned dramatic increase in the popularity of low-volatility strategies.
The cash inflows have raised the valuations of defensive (low-volatility/low-beta) stocks, reducing their exposure to the value premium and thus lowering expected returns. Specifically, as low-volatility stocks are bid up in price, low-volatility portfolios become more “growthy” (which reduces their forward-looking returns).
Specifically, we’ll take a look at the valuation metrics of the two largest low-volatility ETFs, the iShares Edge MSCI USA Minimum Volatility ETF (USMV), with $15.1 billion in AUM; and the PowerShares S&P 500 Low Volatility Portfolio (SPLV), with $7.9 billion in AUM. We will then compare their value metrics to those of the iShares Russell 1000 ETF (IWB), which is a market-oriented fund, and the iShares Russell 1000 Value ETF (IWD).
The table below is based on Morningstar data as of July 7, 2016.
What is clear from the data is that the demand for these strategies has altered their nature. The valuation metrics of USMV and SPLV certainly don’t look like a value-oriented fund. Their price-to-earnings, book-to-market, price-to-sales and price-to-cash flow ratios are all quite a bit higher than those of IWD. In fact, their metrics indicate that both are now more “growthy” than the marketlike IWB. What’s more, the price-to-earnings ratios of both USMV and SPLV were even higher than the iShares Russell 1000 Growth ETF’s (IWF) ratio of 20.7.
