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.
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.