One of the biggest problems for the first formal asset pricing model developed by financial economists, the CAPM, was that it predicted a positive relation between risk and return. But empirical studies have found the actual relation to be flat, or even negative. Over the last 50 years the most “defensive” stocks have delivered higher returns than the most “aggressive” stocks.
Additionally, defensive strategies—at least those based on volatility—have delivered significant Fama-French three-factor (beta, size and value) and Carhart four-factor (adding momentum) alphas.
The superior performance of low-volatility stocks was first documented in the literature in the 1970s, before even the size and value premiums were “discovered.” Since then, the low-volatility anomaly has been demonstrated to exist in equity markets around the globe. What’s interesting is that this finding holds true not only for stocks but for bonds. In other words, it has been pervasive.
Explaining The Low-Vol Anomaly
New research into the premium, combined with the bear market caused by the financial crisis of 2008, led to a dramatic increase in the popularity of low-volatility strategies. While the performance of low-volatility strategies has been strong, investors should be aware of research that shows there are other common factors that provide at least some power to explain that performance.
For example, Robert Novy-Marx, in his 2016 study, “Understanding Defensive Equity,” found that profitability is a significant negative predictor of volatility, and it is the single most significant predictor of low volatility. The research has also found that low-volatility strategies have exposure to term risk (the risk of rising interest rates). Thus, they have benefited from a more-than-30-year secular decline in interest rates, with rates now at historic lows.
As David Blitz, Bart van der Grient and Pim van Vliet, authors of the June 2014 paper “Interest Rate Risk in Low-Volatility Strategies,” explain: “Low-volatility stocks tend to benefit from falling interest rates, which is consistent with the notion that they are ‘bond-like’ stocks, due to their stable cash flows and high dividends.”
Using data covering the period January 1929 to December 2010, the authors found that “consistent with the intuition that low-volatility stocks resemble bond-like stocks ... low-volatility strategies have a higher exposure to bond returns (0.57 and 0.51) than the equity market portfolio (0.34), which, it should be noted, already has a positive bond exposure.” They do add that the bond exposure of low-volatility strategies does not fully explain their long-term added value. They confirmed both of these findings when they looked at global markets as well.
The bottom line is that investors should at least be aware of the exposure to duration risk that low-volatility investing entails. They should also be aware that the recent popularity of low-volatility strategies has led to higher valuations. Prior to their surge in popularity, low-volatility strategies had exposure to the value factor. We can see how this has changed in the table below, which shows value metrics for the iShares Edge MSCI Minimum Volatility ETF (USMV), the largest low-volatility ETF, and compares them to the value metrics of the iShares Russell 1000 ETF (IWB) and the iShares Russell 1000 Value ETF (IWD). Data is from Morningstar as of Sept. 27.