Swedroe: Use Caution With Low Vol Strategies

August 19, 2016

Term Risk

The fact that low-volatility strategies have exposure to term risk (the duration factor) should not be a surprise. Generally speaking, low-volatility/low-beta stocks are more “bond like.” They are typically large stocks, the stocks of profitable and dividend-paying firms, and the stocks of firms with mediocre growth opportunities. In other words, they are stocks with the characteristics of safety as opposed to risk and opportunity. Thus, they show higher correlations with long-term bond returns.

Ronnie Shah, author of the 2011 study “Understanding Low Volatility Strategies: Minimum Variance,” found that over the period 1963 through June 2010, the low-beta strategy had exposure to term risk. The “loading factor” (degree of exposure) was a statistically significant .09 (with a t-statistic of 2.6).

As further evidence, Tzee-man Chow, Jason Hsu, Li-lan Kuo and Feifei Li, authors of the 2013 study “A Study of Low Volatility Portfolio Construction Methods,” found a correlation of 0.2 between the BAB (betting against beta) factor and the duration factor.

Given their positive exposure to term risk, low-volatility stocks have benefited from the cyclical bull market in bonds that we have been experiencing since 1982. That rally cannot be repeated now, with interest rates at historic lows.

And finally, we need to consider if low-volatility strategies have become overgrazed.

Have Low-Volatility Strategies Become Overgrazed?

As with so many well-known anomalies and factors, the problem of potential overgrazing exists. Findings regarding the premium, combined with the bear market caused by the financial crisis of 2008-2009, led to a dramatic increase in the popularity of low-volatility strategies. As one example, as of July 2016, the iShares Edge MSCI Minimum Volatility USA ETF (USMV) had assets exceeding $15 billion.

We’ll examine how cash flows can change expected returns to factors by comparing the valuation metrics of USMV to those of the iShares Russell 1000 ETF (IWB), which is a market-oriented fund, the iShares Russell 1000 Value ETF (IWD), and the DFA Large Cap Value Fund (DFLVX). (Full disclosure: My firm, Buckingham, recommends DFA funds in the construction of client portfolios.) The table below is based on Morningstar data as of July 15, 2016.

 

 

It’s clear that cash inflows have raised the valuations of defensive (low-volatility/low-beta) stocks, dramatically reducing their once-significant exposure to the value premium to zero or negative, lowering expected returns. Specifically, as low-volatility stocks have been bid up in price, low-volatility portfolios have lost their value characteristics, in turn reducing the forward-looking returns. In other words, while low volatility still may predict low volatility, it may no longer result in higher returns than high volatility.

Summary

While it may not yet be resolved whether the low-volatility and low-beta anomalies can be well explained by exposures to other well-known factors, the popularity of the strategy certainly has changed the valuation metrics of low-volatility stocks. At the very least, this should raise a flag of caution for investors who have been enticed by the historical data. Forewarned is forearmed.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

 

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