Not so Simple: Valuations and Low Volatility Strategies

/Not so Simple: Valuations and Low Volatility Strategies

Not so Simple: Valuations and Low Volatility Strategies

By | 2017-08-18T16:59:46+00:00 May 17th, 2016|Key Research, $SPLV, Low Volatility Investing|9 Comments

Low volatility funds are everywhere.

The reasons for their proliferation are clear:

  1. Who wouldn’t want to own something with the label “low volatility” and
  2. Recent performance has been great.

Open the AUM floodgates!

But perhaps not all is well in low volatility land. A recent snippet by Josh Brown hints at the idea that perhaps low volatility is overdone. Charles Bilello at Pension Partners takes Josh’s sentiment a bit further and highlights that the valuation on the securities associated with the typical low volatility fund is richly valued relative to the typical high volatility fund (Jason Zweig has a related piece). For example, Charles shows that SPLV (a low volatility fund) has an average P/E of 21.47, whereas SPHB (a high volatility fund) has an average P/E of 17.89.

No matter what the strategy, if it suggests that you buy expensive growth stocks, that should give you pause since in general buying growth stocks has proven to be a bad idea in the past.

Of course, the biggest splash of cold water on low volatility funds came indirectly from Rob Arnott, a pioneer of “smart beta.” His piece, “How can smart beta go horribly wrong,” which, if you haven’t seen it, states the following:

Large asset flows into low beta [i.e., low volatility] products are now driving valuation levels far above their historical norms.

Arnott suggests–fairly bluntly–that low volatility strategies are in for some expected pain in the future.

But is this true? Perhaps, but understanding why is more complex…

Two takeaways from the paper we investigate:

  1. The research we highlight suggests that low volatility strategies, even when deployed during periods when low volatility stocks are expensive, can still serve a role in a portfolio. One wants to avoid periods when low volatility portfolio valuations are extremely expensive relative to high volatility portfolios, but just because low volatility stocks are expensive, doesn’t mean they can’t help an investor’s portfolio, in expectation.
  2. Of course, this assumes that an investor can’t already access targeted exposures to active value and momentum exposures. If an investor can already deploy value and momentum strategies, low volatility strategies don’t do much for a portfolio except in cases when the valuations on low volatility portfolios are extremely cheap relative to high volatility portfolios.

Let’s dig a little deeper…

What are we to make of the low volatility debate? Is pain on the horizon?

We don’t disagree with much of the sentiment identified above, and we’ve done some fairly extensive analysis of the low-volatility anomaly here, here, here, and here. As naturally-inclined value investors, buying anything that is expensive receives a knee-jerk answer: “No.”  But over the years I’ve come to appreciate trend-following and momentum philosophies. So while I’ll never be deterred from the value investing credo, I also understand that it isn’t the only answer. Low volatility falls in an interesting camp, even if it isn’t necessarily a “value investing” camp. However, our interest in low volatility investing comes with reservations. We’ve covered some research that hints that the low-volatility anomaly isn’t robust here, here, and here. More work needs to be done.

In other words, I’m still confused. But I went looking for recent recent work in the peer-reviewed literature and ran across the paper, “Low-Volatility Cycles: The Influence of Valuation and Momentum on Low-Volatility Portfolios. Here is a shortened abstract from the paper:

Research showing that the lowest risk stocks tend to outperform the highest risk stocks over time has led to rapid growth in so-called low-risk equity investing in recent years….Our results suggest time-variation in the performance of low-risk strategies is likely influenced by the approach to constructing the low-risk portfolio strategy and by the market environment and associated valuation premia.

Bottomline: Valuations do matter when it comes to low volatility investing. But low volatility only completely loses its mojo when valuations are extreme.

What does the paper say?

First, the paper identifies that low volatility stocks beat high volatility stocks — confirming what we all already knew. Below is a chart from the paper outlining the cumulative returns for the 5 beta quintiles (1 = low beta, 5 = high beta).

low vol beats high vol

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

But here is where it gets interesting. The authors look at the time series behavior of the average “cheapness” for the low volatility portfolio and the high volatility portfolio over time. The figure below summarizes their analysis:

FAJ Low Volatility Cycles The Influence of Valuation and Momentum

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Note that historically there is a positive spread in the “cheapness” characteristic between low volatility and high volatility portfolios (i.e., low volatility portfolios look like value and high volatility portfolios look like growth). Put another way, in general, low volatility stocks have also tended to be cheap (value) stocks; by contrast, high volatility stocks have also tended to be expensive growth stocks.

But how does this affect the performance of the strategy? Does it matter whether low volatility stocks are especially cheap, or not especially cheap? A common hypothesis is that low volatility only works when it is cheap, but it fails when it is expensive (the hypothesis proposed by Arnott).

The authors assess this in Table 2 of their paper. The far left column sorts portfolios based on 5 valuation regimes identified based on the spread in valuation metrics between low volatility and high volatility portfolios (pictured in the figure above).

Here’s how it works. The authors take a given month and divide the market into 5 volatility quintiles. Thus, at the extremes, there will be a high volatility quintile, and there will be a low volatility quintile. Next they say: “Given we have both a high volatility quintile and a low volatility quintile in this month we are looking at, how cheap are the stocks in these 2 extreme quintiles relative to each other?” That is, is there a large spread or is there a small spread? If the spread is large, this outcome will be captured in a high B/P spread quintile. If the spread is small, this outcome will fall in a low B/P spread quintile.

Next, now that we have identified valuation 5 spread “regimes,” for the high vol-low vol spreads, we can go ahead and further sort these regimes into volatility quintiles. That is, we can ask questions like, “given a regime where valuation spreads were very high across low and high vol portfolios, within this valuation regime, did volatility do a good job of separating winners from losers, or a bad job?”

Quintile 5 represents the answer to this particular question. At times when there was a large B/P valuation spread between the high and low the volatility portfolios, volatility appears to do a good job of further separating winners from losers. Average value-weight returns go from 0.55% for high beta, all the way up to 1.42% for low beta. Low beta seems to work well when valuation spreads are large! Good job!

Meanwhile, Quintile 1 represents times when there was a small B/P spread between the high and the low volatility portfolio. What happens here? Volatility does not do a good job versus how it did in Quintile 5 at further separating winners from losers. Here, average value-weight returns actually decreased,  going from 0.35% for high beta, down to 0.13% for low beta. Low beta is actually working against us! Bad job!

The far right column is the average return calculation during these valuation regimes and represents the spread in returns between low volatility and high volatility portfolios.

The beta neutral spread (100% long low volatility and 25% short high volatility, which is roughly beta neutral) has positive returns in all valuation environments, except the most extreme (-12bps), where it breaks down. In fact, even when low volatility minus high volatility valuation spreads are pretty extreme (quintile 2), there is a 69bp spread in avg returns, which is close to the avg return in regimes when low volatility stocks are really cheap relative to high volatility stocks (80bps).

valuations and low vol

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Is this really just another value and momentum story? Kinda…

All this analysis perhaps begs a question: is low volatility really just an exposure to value and momentum? The authors examine this via factor regression analysis in table 3 Panel B. Interestingly, “alphas,” or the average excess return associated with the strategy after controlling for exposures to the market, size, value, and momentum, are only reliably positive in the regime when low volatility stocks are way cheaper than high volatility stocks.

low vol alpha

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Perhaps I’m misinterpreting (wouldn’t be the first time), but the results seem to suggest that low volatility is much ado about nothing, EXCEPT, when the spread in valuations between low vol and high vol are most extreme (i.e., quintile 5).

So this brings us back to the original question from the beginning of this post, i.e., is low vol investing overdone, given current market conditions?

Based on the analysis from the paper above, the answer has to do with whether valuation spreads are large or small today. As many authors have pointed out, the valuation spread between low volatility and high volatility portfolios is pretty extreme.

As highlighted in the paper, low vol only gets really interesting when spreads are large. But today, spreads are not large; they are negative! When spreads are negative like they are today, you can engineer the same risk exposures promised by “low vol” strategies, by leveraging value and momentum. So what’s the point?

Maybe there is some mojo left in low volatility, but for the most part, value and momentum already capture most of the benefits, at least that’s what it looks like based on the research paper and the current state of affairs on low volatility portfolio valuations.

Curious to hear thoughts from others and we’ll have to do some more research on this subject in the future. The case is not entirely closed on low volatility, but identifying how to best exploit the effect will take some thinking…


Low-Volatility Cycles: The Influence of Valuation and Momentum on Low-Volatility Portfolios

Garcia-Feijoo, Kochard, Sullivan, and Wang
A version of the paper can be found here.
Want a summary of academic papers with alpha? Check out our Academic Research Recap Category.

Abstract:

Research showing that the lowest risk stocks tend to outperform the highest risk stocks over time has led to rapid growth in so-called low-risk equity investing in recent years. We examine the performance of the low-risk strategy previously considered in the literature and of a beta-neutral low-risk strategy more relevant to practice. We demonstrate that the historical performance of low risk investing, like any quantitative investment strategy, is time-varying. We find that both of our low-risk strategies exhibit dynamic exposure to the well-known value, size, and momentum factors and appear to be influenced by the overall economic environment. Our results suggest time-variation in the performance of low-risk strategies is likely influenced by the approach to constructing the low-risk portfolio strategy and by the market environment and associated valuation premia.


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About the Author:

Wes Gray
After serving as a Captain in the United States Marine Corps, Dr. Gray earned a PhD, and worked as a finance professor at Drexel University. Dr. Gray’s interest in bridging the research gap between academia and industry led him to found Alpha Architect, an asset management that delivers affordable active exposures for tax-sensitive investors. Dr. Gray has published four books and a number of academic articles. Wes is a regular contributor to multiple industry outlets, to include the following: Wall Street Journal, Forbes, ETF.com, and the CFA Institute. Dr. Gray earned an MBA and a PhD in finance from the University of Chicago and graduated magna cum laude with a BS from The Wharton School of the University of Pennsylvania.
  • Steve

    Ha, I was just revisiting low vol yesterday after a long break from reading the literature. Re-read some Blitz to give me some pro low-vol so I could have a debate with myself about former conclusions.

    I go back and forth on volatility (and quality – which I no longer think of as strictly a ‘factor’ – it’s a conglomerate or composite of ideas, a factor should stand alone. But anyway, that’s quality, this is about volatility).

    I’ve always said, including when Novy-Marx profitability was becoming famous, that it always matters the price you pay. Cheap helps everything, even momentum (i.e. cheap momentum will beat expensive momentum over the long term, with lots of periods of stress in between). All other ‘factors’ can become expensive. Cheap cannot. Cheap can become expensive relative to history or an absolute measure of cheapness (for example, Graham’s NCAV stocks are ‘absolutely’ cheap, but there aren’t many opportunities outside of crashes / depressions etc). But at least, ‘current relative cheapness’ can never disappear…not unless all stocks become priced at the same level (which is for all purposes, impossible).

    Back to volatility.

    I’ve seen it called nothing more than a poor exposure to value by some, and I’ve seen it called a poor exposure to ‘quality’ (Novy-Marx says that). I’ve seen it advocated alongside value and momentum (Blitz). I’ve seen it called more a high-volatility play (i.e. long/short) making it less relevant to the long only investor (Asness)

    Reason for low volatility working: I’ve always thought of it as a behavioural longshot bias, as seen on parimutuel betting pools everywhere. Some horses really should be 1000/1 or more, but they don’t go out that high, because the lottery effect kicks in, so it goes out at 100 or 200/1 – a huge difference in odds. The betting pool might have a takeout / rake of 15%, and if punters bet on horses randomly, all odds ranges would have the same expectation… -15% But all over the world, that doesn’t happen. Favourites have a small negative edge less than the rake, whilst longshots have a gigantic negative edge – much greater than the rake. Incidentally, (from memory – it was a long time ago I was into this stuff)…the Asian markets were a slight exception, in that they were more into favourite numbers etc, i.e. more lottery players than handicappers, so to speak. That might no longer be the case. Anyway – I always thought the same effect happens with volatility (and profitability, for that matter).
    Blitz, in whichever paper I was reading, suggested that one of his reasons was due to the tracking error. i.e. the worse tracking error of volatility is one of the reasons for its success. I thought that was a cool reason.

    My current practical summary – from my perspective (DIY, indie, small-time, long only investor)….

    Low volatility and ‘quality’ are not worth pursuing on their own.
    Used *within* a value and/or momentum context, they probably won’t hurt – and they may, in fact help (on the downside, as defensive factors).

    That’s basically the sum of my current conclusion (as with you, I reserve the right to change conclusions at any time!)

  • I’ll limit my response to 2 words: I agree.

  • disqus_xKlysnzLJR

    Interesting article Wes.
    I think it is likely to continue to outperform as the bear market continues and people associate low vol to low risk/defensive strategy (even though it is not per se). Its a trend, and as long as it continues, it will keep feeding on itself until it changes and then I think we are likely to see a scenario where people are surprised by the damage this strategy can cause to their portfolios.

  • trend-following the exposure probably isn’t a bad idea. Valuation-based timing is usually too painful and you always end up being “early.” After the fact it is a “good idea,” but that doesn’t account for reality. ha!

  • Here is a recent AQR paper, which seems to contradict the paper highlighted. This is possibly due to the way “valuation” spreads are calculated.
    A good read alongside this post
    https://www.aqr.com/library/aqr-publications/are-defensive-stocks-expensive-a-closer-look-at-value-spreads

  • dan knight

    I wonder if what’s lost in the analysis of low-vol strategies is the simple reduction in average returns vs. geometric returns, or “volatility drag”, which is approximated by 1/2 x Variance. Low vol stocks tend to stay low vol, so turnover is also mitigated, and thus actual net-of-transactions costs of the strategy stay close to gross, (trivial now with ETFs) and the increased compounding benefit of the lower realized volatility is likely the most significant contributor to the strategy’s performance. Any thoughts or research responding to this theme?

  • Hey Dan,
    I don’t have the data in front of me so I can’t say definitively that low vol has lower turnover, but that certainly makes sense at first glance. And this is especially true in the historical time series because low vol is so related to value, which tends to have lower turnover than things like momentum. Now that low vol is not so “valuey” it is hard to say what the turnover might look like in the future…

    As far as the geomean vs arithmetic mean, I haven’t seen anything specific on this idea.

    One thing I’ve been informally thinking about is the dynamics of a “blow up” in low vol. If this happens, the low volatility stocks become high vol, and the high vol stocks may become low vol. So you could have huge swaths of capital engaging in massive turnover across past low vol stocks (which are now high vol) and past high vol stocks (which are now relatively low vol). Then as the turnover goes into past high vol stocks (which are now low vol), this may dynamically make them turn back into high vol…and the same for the past low vol stocks (which become high vol), they could then become low vol again after people sell them all and they settle. Anyway, if low vol blows up in a big way the dynamics of how it settles is going to be interesting. The only thing certain is there will be a lot of happy market makers catching bits of $ on commissions and b/a spreads. ha!

  • dan knight

    Since Value tends to have a strong sector-bias, we see “blowups” in Value from time to time (ie Financials, Energy) so the blow up concept wouldnt be unique to low vol. I think Utilities, Healthcare, Staples, the usual low vol sectors, could experience their own blow ups independent of valuation, but I don’t think the high valuations create an exogenous risk above and beyond what Value has experienced or Momentum’s kurtosis problems. I also agree that a V/M combo explains much of low vol’s performance, but still the improved geometric performance from reduced volatility is orthogonal to the other factors

  • Grant Colthup

    in response to your post Dan, Dan diBartolomeo (Northfield) gave an excellent presentation Low Volatility Equity Investing: Anomaly or Algebraic Artifact) on that exact topic and found it plays a significant part.

    IMO there is also a link between interest rates declining for the past 40yrs and low volatility investing working (since we dont have good counterfactual examples it is hard to assess the validity of my claim). My feeling is that when rates were higher, investors faced a more difficult choice between investing in a stock that might return 15% and a bond returning 10%. But when rates are low (especially currently), the choice is between a bond expecting to return 1-2% versus a stock returning 5-6%, the stock now is return 3-5x more than the bond versus 1.5x when rates were higher.

    Lastly, as Steve correctly points out, low vol by itself (especially currently) is likely to produce poor results (due to valuation concerns of some parts of the low vol universe). Also a prudent low vol strategy requires industry/sector limitations or else the returns become dominated by exposure to those sectors.