Low-Vol Strategies’ Shifting Nature
What is clear from the data is that the demand for low-volatility strategies has altered their nature. The valuation metrics of USMV no longer look like a value-oriented fund. Their price-to-earnings, price-to-book and price-to-cash flow ratios are each quite a bit higher than IWD’s metrics. In fact, their metrics indicate that both funds look quite a bit “growthier” compared with the marketlike IWB.
While we should always prefer buying stocks at lower valuations, what we don’t know is how big of an impact valuations may have on low-volatility strategies. This leaves the question of whether valuations are a first-order issue, as they are with the overall stock market and value stocks, or a minor issue (or even a nonissue), as is the case with momentum. Thanks to research from Pim van Vliet of Robeco, we can attempt to answer that question.
In a 2012 paper, van Vliet examined the returns to low-volatility strategies over the period 1929 through 2010. Following is a summary of his findings.
First, he found that, while on average, low-volatility strategies tend to have exposure to the value factor, that exposure is time-varying. For example, he found that, on average, low-volatility has a price-to-book (P/B) ratio that’s 0.05 lower than the market, but this varies from 0.7 in the 1940s (growth) up to -0.6 in the early 2000s (value). Low volatility spends about 38% of the time in the growth regime and 62% of the time in the value regime.
Second, when low volatility exhibits positive exposure to the value factor, it generally has outperformed the market, returning an average of 9.5% versus the market’s 7.5%. It has also exhibited lower volatility, producing a standard deviation 3 percentage points smaller (13.5% versus 16.5%). However, when low volatility exhibited negative exposure to value (positive to growth), it underperformed the market, returning an average of 10.8% versus the market’s 12.2%. However, it continued to have lower volatility (15.3% versus 20.3%). The result has been a higher risk-adjusted return in either regime.
The bottom line is that, in either regime, low volatility predicts lower future volatility. However, when low volatility has negative exposure to the value factor, as it does now, it also forecasts below-market returns. When it has positive exposure to the value factor, you get both lower volatility and above-market returns (likely due to value factor exposure). This suggests that one could create an enhanced low-volatility strategy, one that screens for value as well.
Low-volatility strategies have performed historically well. However, they have benefited from both their exposure to term risk and their increasing popularity. We also know that their returns are at least partly explained by exposure to the profitability/quality factor. In addition, given the negative exposure that low volatility currently has to value, it’s signaling that future returns are likely to be below-market.
Given that the strategy’s popularity has led to high current valuations, and understanding that it’s the high-volatility strategies that have, historically, very poor returns, investors may be best served today by simply avoiding high-volatility strategies, as opposed to seeking out low-volatility strategies (at least in the case of equities; low volatility has been shown to work in bonds as well).
At the very least, if you are investing in low-volatility strategies, you should consider their exposure to term risk, and perhaps lower exposure to that factor in the rest of your portfolio. Also, remember that another—and in my view, a more efficient—way to dampen portfolio volatility is to increase your exposure to other well-known factors with premiums (size, value, momentum, profitability/quality) while lowering your exposure to market beta and increasing your allocation to safe bonds.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.