Swedroe: Skeptical On The Low-Vol ‘Factor’

The superior performance of low-volatility stocks was initially documented in the literature back during the 1970s, by Fischer Black, among others. That’s even before the size and value premiums were officially “discovered.”

And since its existence became known, two main explanations for the low-volatility phenomenon have arisen. They are that:

• Many investors are either constrained against the use of leverage or have an aversion to it. Such investors tend to seek higher returns by investing in high-beta (or high-volatility) stocks, despite the fact that the evidence shows they have delivered poor risk-adjusted returns. Limits to arbitrage and aversion to shorting, as well as the high costs associated with shorting such stocks, prevents arbitrageurs from correcting the pricing mistake. Because these investors seem to prefer unleveraged risky assets to leveraged safe assets, they hold portfolios of high-beta assets with lower alphas and Sharpe ratios than portfolios of low-beta assets.
• Some investors have a “taste,” or preference, for lotterylike investments. This leads such investors to “irrationally” invest in high-volatility stocks (which have lotterylike distributions) despite their poor returns. In other words, they pay a premium to gamble.

The severe bear market that occurred from 2008 through early 2009 only served to intensify investor interest in low-volatility stocks. And Wall Street, of course, responded by developing low-volatility products to meet this new demand.

Surveying The Research

Heightened investor interest also led to more academic research on the low-volatility phenomenon. Following is a brief summary of some important conclusions from the literature. Together, these findings provide other possible explanations for the phenomenon and, at the very least, call into question the viability of low-volatility strategies:

• While high-volatility stocks have abysmally poor returns, there’s very little difference in returns between low and medium residual volatility stocks.
• Many high-volatility stocks are very small, together representing just 2.4 percent of the market. Thus, their impact on a market portfolio is marginal.
• Live long/short portfolios that short high-volatility stocks are unlikely to generate abnormal profits due to high turnover and the high costs of shorting small, illiquid equities.
• Stocks that have negative momentum (poor recent returns) and small growth stocks show poor returns. A market portfolio with rules that exclude these stocks will produce similar results to a low-volatility strategy.
• Low-volatility strategies provide exposure to the well-known value premium.
• Low-volatility portfolios earn a duration premium because the greater stability in their cash flows tends to lend them a bondlike characteristic. And we’ve been in a secular bull market for bonds for more than 30 years.
• The low-risk effect has been weaker since 1990. Weaker results post-1990 could be a result of improved market efficiency, including the impact of regulations passed that year aimed at reducing fraud associated with trading penny stocks. Since then, the number of stocks on public U.S. exchanges has shrunk dramatically. One explanation is that regulatory expenses (for example, expenses related to the Sarbanes-Oxley bill) have raised the hurdle for becoming a public company, reducing the total number of high-beta stocks.
• High volatility on its own isn’t an indicator of poor future returns. On average, stocks with high prior-period volatility underperformed those with low prior-period volatility. But the comparison is misleading because among high-volatility stocks, those with low short interest actually experience extraordinary positive returns. For the period from July 1991 through December 2012, stocks with high volatility and low short interest would have outperformed the Center for Research in Security Prices (CRSP) value-weighted index by 9 percentage points a year. It has long been known that stocks with high short interest perform poorly. Thus, simply screening these stocks out of a portfolio should improve returns.

Inside Low-Vol Strategies

The authors of a 2014 paper, “A Study of Low-Volatility Portfolio Construction Methods,” found that the returns of low-volatility strategies are well-explained by their exposure to the value premium, as well as to the term premium. They explain that, while a “significant duration premium is surprising for an equity portfolio, it is unsurprising for low-volatility portfolios, which tend to provide stable income with long bond-like volatility, to exhibit some fixed-income characteristics.”

And even though the authors did not conclude that the size and momentum factors contributed in a meaningful way to the outperformance of low-volatility portfolios, they did discover that the “BAB” factor—“betting against beta—made an impact.

The BAB factor was proposed by Andrea Frazzini and Lasse Pedersen in their 2011 study, “Betting Against Beta.” Frazzini and Pedersen found that low-beta stocks outperform high-beta stocks. They also found that low-beta stocks are likely to be larger, have higher book-to-market ratios (which suggests they are value stocks) and have higher returns over the prior 12 months (a reflection of the momentum factor). The factors, however, don’t fully explain the BAB premium.

The Advantages Of Diversification

Diversification is another issue related to low-volatility strategies that investors should consider. Traditional core equity strategies tend to have market betas of 1, and no exposure to the other factors. Thus, the risks of market portfolios are dominated by the single beta factor.

Because low-volatility portfolios have lower exposure to the market risk factor and higher exposure to the value, BAB and duration factors, they’re more diversified across the different sources of returns (specifically, value, low volatility, duration and market).

Have Low-Volatility Strategies Become Overgrazed?

The evidence suggests both that low-volatility strategies may not be as attractive in live portfolios as they appeared to be on paper (due to implementation costs) and that their returns are well-explained by exposure to other factors.

In addition, as is the case with so many well-known anomalies and factors, the problem of potential overgrazing must be considered. As low-volatility stocks are bid up in price because of increased flows into the strategy, low-volatility portfolios may lose their value characteristics, which would reduce their forward-looking returns.

Also, recalling our 30-year bull market in bonds, the potential, if not the likelihood, of rising interest rates indicates that it is possible that returns related to the duration-risk premium could be significantly lower than historical data might suggest. This could further detract from forward low-volatility performance. With this in mind, we’ll examine the portfolios of some low-volatility ETFs.

A Look At Low-Vol ETFs

Specifically, we’ll take a look at the valuation metrics of the market’s two largest low-volatility ETFs: the PowerShares S&P 500 Low Volatility Portfolio (SPLV | A-46), with $5 billion in assets under management; as well as the iShares MSCI USA Minimum Volatility ETF (USMV | A-62), with $3.5 billion in assets under management.

We’ll then compare their value metrics to those of the iShares Russell 1000 ETF (IWB | A-93), which is a market-oriented fund, and the iShares Russell 1000 Value ETF (IWD | A-87). The table below is based on Morningstar data as of Dec. 1, 2014:

What’s clear from the data is that the demand for these strategies has altered their very nature. The valuation metrics of SPLV and USMV 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 funds are now somewhat “growthier” than the marketlike IWD. What’s more, the evidence demonstrates that, over the long term, the annual value premium has been 4.9 percent.

That low-volatility portfolios in the past have provided marketlike returns without any greater volatility is an anomaly that cannot be explained by the efficient markets hypothesis. As is the case with many anomalies, their discovery often leads to their disappearance. At the very least, investors should recognize that cash flows into these strategies have changed their nature, raising concerns. In the end, buyers should beware.

Larry Swedroe is the director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.