Different theories behind setback in low-volatility equities’ popularity — though investors may want to revisit them
As investors showed a preference for protection and defense throughout most of 2019, it’s hardly surprising that low-vol ETFs were endorsed and adored in the earlier parts of the year. But fast forward to today, and it seems that the love affair has cooled considerably.
“Before the beginning of November, for example, the low-volatility stock ETF with the most assets under management— iShares Edge MSCI US Minimum Volatility ETF (USMV)—had experienced 16 straight months of net inflows,” wrote Wall Street Journal columnist Mark Hulbert. Citing Ned Davis Research, he said the fund had averaged over US$1 billion a month in inflows.
“In November, in contrast, the ETF experienced net outflows of [US$527 million], according to the Ned Davis firm,” Hulbert said.
One reason put forward by analysts is the factor’s recent disappointing performance. After outperforming the broad market for several years, low-volatility strategies trailed it significantly in September and October. Over that two-month period, USMV gained a mere 1.2%, in contrast to the S&P 500’s total return of 5.9%.
As Hulbert pointed out, data from S&P Dow Jones Indices shows that the S&P 500 Low Volatility Index has lagged the broad benchmark in nearly half of all two-month periods since 1972, reflecting the fact that no long-term winning strategy comes without periods of short-term underperformance.
“[T]he low-volatility strategy’s outperformance before September wasn’t unprecedented,” he added, noting that the approach has bested the benchmark by even wider margins in some three-year periods, including during the 2008 global financial crisis and the dot-com bubble burst of 2000.
Another criticism levied against the strategy is that low-volatility stocks have become overvalued. Data from iShares shows that USMV’s price-earnings ratio, based on trailing 12-month earnings, is 17% higher than the S&P 500’s.
In defense of low-volatility strategies, South Street Investment Advisors Chief Strategist Nardin Baker argued that the underlying portfolio has shifted away from value toward growth stocks, whose P/E ratios have always been above average. While growth equities are usually more volatile than others — they would take outsized losses in the event of an economic recession — the Federal Reserve’s easy-money policies have effectively lessened the risk of that happening.
The upshot, Baker said, is that growth equities have been imbued with value-stock-like volatility, and that investors’ avoidance of low-volatility stocks should persist to the extent that they believe the Fed’s policies will remain.
A third possibility is that low-vol strategies’ outperformance doesn’t stem from some unique quality, as some studies have found that a mix of other styles or factors would have worked just as well. But Kent Daniel, a finance professor at Columbia University and a former co-chief investment officer at Goldman Sachs, said in an interview that those studies failed to consider other characteristics of low- and high-volatility portfolios that impacted their returns; upon correcting for those variables, he said that he and three other colleagues found that the low-vol strategy isn’t reducible to other styles.
“Prof. Daniel adds that, while there is never a guarantee that a strategy will continue working, he is unaware of any evidence that the low-volatility strategy has stopped working,” Hulbert wrote.
