Value and Low Volatility
The fast pace of growth raises the question: Does the rapid flow into this space erode the strategy’s effectiveness in delivering attractive risk-adjusted returns? This is a legitimate concern. After all, naïve low volatility portfolios are designed to reduce market risk but lack an investment thesis on returns. If cash equivalents were an option, they would dominate the low volatility portfolio and produce very uninteresting returns. Investors, we believe, are interested in more than merely minimizing the volatility of their equity portfolio; they are also interested in earning an “appropriate” return. The investment decision makes sense only in the context of trade-offs between return and risk.
Empirical research shows that low volatility strategies reallocate risk from the market factor to other reliable sources of equity returns, forming a more risk-balanced portfolio. Lower volatility is the natural consequence of this risk diversification (Chow, Hsu, Kuo, and Li, 2013). It is fortuitous that, in developed markets, low volatility stocks earn an anomalous premium due to investors’ “leverage aversion” (Black, 1972; Frazzini and Pedersen, 2011) or “speculative demand for gambling” (Baker, Bradley, and Wurgler, 2011), and that they also benefit from a value premium. These anomalous premiums, historically, have more than offset the loss in return associated with the reduction in portfolio risk. However, as Chow et al. (2013) discovered, in emerging markets, low volatility stocks have not historically been the “cheap” stocks and can indeed be the high price-to-book stocks (see also Oey, 2013). It is possible that, if low volatility stocks were to become more expensive in the developed world (exhibiting growth-like P/B ratios), then the premium they earn might no longer suffice to offset the loss of return due to reduced market exposure.
Is that the case now? Let’s take a look at the valuation ratios of three naively constructed low volatility strategies: Minimum Variance, Inverse Beta, and Inverse Volatility.1 Market capitalization-weighted portfolios will serve as benchmarks (Table 1). In developed markets, the low volatility group has historically tended to have higher earnings yields and lower book-to-price ratios than the market cap-weighted portfolio. However, over the past 10 years, the cheapness or “valueness” of developed market low volatility stocks seems to have diminished. As of May 1, 2013, the earnings yield and B/P ratio data indicate that low volatility strategies have become more expensive than the market cap-weighted core indices. In emerging markets, the valuation level for low volatility strategies has never been lower, relative to the core equity index—but emerging market low volatility portfolios are growing less attractive, especially considering that the benchmark index has fallen quite a bit this year.