Shall we invest in the equity market? And, if so, shall we invest in the low volatility segment of the equity market? In this article, we describe and apply two approaches to evaluating market levels. The first approach, based on hypothetical long-term performance, estimates prospective returns of the broad equity market and the low volatility segment when price-to-earnings (P/E) ratios are below and above 20x. The second views low volatility investments as a hybrid of equity and fixed-income assets, and estimates fair valuation levels based on a range of market P/E ratios and low volatility betas. Nobody can reliably time the market, but this analysis may be helpful to investors who are currently thinking about committing assets to a low volatility strategy.
Whenever something new comes on the market, from the latest model of smart phone to the most advanced electric car, many of us are eager to prove how cool we are by promptly buying it and—of course—showing it off in social media outlets. Not everybody is as conservative as I am when contemplating a purchase. I always wait for reviews, and, by nature and training, I think critically about the reviewers’ expertise, independence, and standards of excellence as well as about the points they make. Technology advances so quickly that I hesitate to buy the newest release or the product with the most novel features; if the manufacturer doesn’t follow up soon with a faster, cheaper, more reliable version, the competition surely will. In short, when shopping for technology-intensive products, I make purchase decisions slowly and cautiously.
But when it comes to investment decisions I seem to take the lead. Many investors prove to be considerably more conservative than one might expect. It takes years of debate before a new concept, strategy, or design is broadly adopted, even though its advantages may be readily apparent. For example, when I joined Research Affiliates, we were pretty much all alone in advocating non-price-weighted index investing. And, to their credit, investors moved slowly and cautiously. But today—nine years later—the concept seems to be widely accepted in the investment community. We see asset owners collectively committing billions of dollars to smart beta strategies, leading consultants strongly recommending smart beta mandates, and academics and practitioners alike writing papers on this still-new way of thinking and investing. Smart beta investment strategies have come into their own.
For the past three years, I’ve been working in the area of low volatility investing, and here, too, I see much the same pattern: years—in this case, decades—of debate about what causes the “anomaly,” followed at last by a rapid rise in global assets under management. Low volatility strategies clearly had the potential, all along, to generate superior risk-adjusted returns. But only after the shock of the Global Financial Crisis, when investors were stunned (once again) by the drawdown risk inherent in equity exposures, did low volatility strategies become a popular choice.
It is entirely reasonable for investors to educate themselves and evaluate the risks before buying into a new strategy. Indeed, investing without understanding a strategy and weighing the risk of an adverse outcome would be irrational. It is also reasonable for money managers to worry about the viability of their firm and the future course of their career. With one exception,1 smart beta strategies tend to be contrarian, and they require patience; they can underperform cap-weight benchmarks for extended periods of time. Even for years. Managers know that clients may not prove steadfast in their commitment to investing for the long term; some investors are always liable to withdraw funds at the worst possible moment—just before declining stock prices reverse direction and head back toward their long-term averages. Thus investors may temporize, and managers may not be strongly motivated to help them make a timely decision about a promising new strategy. In the meantime prices may appreciate considerably.
Future Returns by P/E Range
The price of low volatility assets has, in fact, risen in step with or even faster than the broad cap-weighted index over the past five years. At this juncture, there are two distinct market timing questions to answer: Shall we invest in the equity market? And, if so, shall we invest in the low volatility segment of the equity market? Nobody can dependably time the market, but historical experience may offer some guidance. Let’s review information pertinent to each question separately.
For this research we created a benchmark portfolio, the CAP 500, by market capitalization weighting the 500 largest U.S. stocks in our universe. We also constructed a low volatility portfolio containing the 100 least volatile stocks in the benchmark, weighted by the inverse of their volatility. We simulated the performance of the benchmark and the low volatility strategy over the period from 1967 to 2013. Table 1 shows the average 1-year, 3-year, and 5-year benchmark and strategy returns in two trailing 12-month price-to-earnings (P/E) ranges and in aggregate. The P/E ratios used were those of the market-cap benchmark as of the beginning of each year in the sample period.