IS LOW VOL THE NEW VALUE?
Same, Same, but Different
September 2019. Reading Time: 10 Minutes. Author: Nicolas Rabener.
This research note was originally published by the Savvy Investor blog. Here is the link.
- The Low Volatility factor exhibited significant exposure to Value since 1989
- The factors were highly correlated in the 1990s, but less after the financial crisis
- Quantitative easing was positive for Low Volatility, but negative for Value
Riding the Ferris wheel in an amusement park is the equivalent of investing in a Low Volatility strategy in the stock market. It is all about experiencing a smooth ride with no hidden surprises that might affect the emotional well-being of the theme park visitor. In contrast, taking a roller coaster ride is like being a Value investor. It will be rough and scary, but hopefully worthwhile once on solid ground again.
However, although investors pursuing a Low Volatility strategy seem to have asymmetrical interests to Value investors, the underlying portfolios are not always that different. For example, the technology sector contributes a meaningful amount of stocks to the short portfolios of both factors as tech stocks are typically volatile and expensive.
The most significant difference for investors has likely been the performance in recent years. Value generated negative returns in nine out of the last ten years while Low Volatility has been leading the factor scoreboard almost every year.
Although this would include a healthy dose of performance chasing, investors might question if the two factors are similar enough to replace Value with Low Volatility in investment portfolios?
We focus on the Value and Low Volatility factors in the US stock market. The factor performance is calculated by constructing long-short beta-neutral portfolios of the top and bottom 10% of stocks ranked by their factor definitions. Only stocks with a minimum market capitalization of $1 billion are included. Portfolios are rebalanced monthly and each transaction incurs costs of 10 basis points.
FACTOR EXPOSURE ANALYSIS
First, we conduct a regression-based factor exposure analysis of the long-short Low Volatility factor in the US stock market to detect if there is any relationship with other common equity factors.
The result reveals a significant positive exposure to the Value factor over the last 30 years. We also observe exposure to other factors, although smaller in nature. Given the magnitude of the factor beta to Value, Low Volatility could have been regarded as a proxy, which is somewhat surprising given the different strategy objectives.
Second, we analyze the portfolio characteristics that may explain the relationship between the two factors. The Low Volatility factor is defined as buying stocks that exhibited relatively low and shorting stocks that had high volatility over the last 12 months. The long and short portfolios can be contrasted by measuring the average betas to the stock market, which were 0.5 and 1.7. In comparison, the Value factor featured similar portfolio characteristics, although naturally less extreme given a different stock selection methodology.
Analyzing the portfolio from a valuation perspective highlights that Value, which is defined as buying cheap and selling expensive companies, featured a large negative spread between the long and short portfolios as measured in price-to-book multiples.
Interestingly, the Low Volatility factor also had a negative valuation spread, highlighting further similarities in portfolio characteristics.
BREAKDOWN BY SECTORS
Next, we analyze the long and short portfolios of both factors by sectors in the period from 1989 to 2018. The long portfolio of the Value factor was dominated by financial stocks, which ranked cheap against other stocks and comprised more than 30% of an equal-weighted portfolio. In contrast, the long portfolio of the Low Volatility factor, i.e. low-risk stocks, featured mainly utility and real estate companies, highlighting substantially different portfolios.
However, the short portfolios were more comparable as technology, healthcare, and consumer discretionary sectors contributed most stocks for both factors.
Expensive stocks seem to be volatile stocks and vice versa, while this does not seem to hold for cheap and low-risk stocks.
VALUE VS LOW VOLATILITY PERFORMANCE IN THE US
The analysis so far has revealed that the Value and Low Volatility factors share some characteristics like negative net betas, negative valuation spreads, and the same sector biases in the short portfolio. However, the long portfolios were significantly different, which should reflect in differentiated performance.
Well, a picture is worth a thousand words. We observe that the Low Volatility factor outperformed the Value factor by a large margin over the last 30 years, however, that the trends were almost identical for decades. Both factors experienced a dramatic drawdown during the tech bubble in 2000 when cheap and low-risk stocks fell out of favor.
The major difference seems that the Low Volatility factor generated positive returns when the Value factor performance was flat, which was especially pronounced from 2010 onward. A casual observer might comment that both provided the same kind of exposure by simply looking at the chart, but that Low Volatility has a superior stock selection methodology.
A less casual observer might be concerned that having exposure to both factors in a portfolio essentially represents the same risk. And indeed, the correlation between the Value and Low Volatility factors in the US was exceptionally high between 1993 and 2005, although random thereafter.
It is interesting to explore why cheap and low-risk, as well as expensive and high-risk stocks, traded so similar for such a long period and what broke the relationship. The factors started to trade differently when investors began selling cheap stocks like financials at the onset of the global financial crisis in 2007. In contrast, low-risk stocks performed well during that period, but underperformed in the recovery thereafter when beaten-down stocks became popular again.
However, why did the correlation not increase after 2009 again? One reason is likely the quantitative easing programs of the US Fed. Interest rate-sensitive sectors like utilities and real estate, which make up the majority of Low Volatility’s long portfolio, benefited from decreasing interest rates as it boosted earnings and demand for stocks that can be viewed as bond-proxies. In contrast, financial stocks like banks and insurance companies were negatively impacted as their profit margins compressed.
Investors that sort the stock market for cheap stocks are primarily looking to generate excess returns by buying companies that might be somewhat unpleasant to hold given firm- or sector-specific issues. On the other hand, investors buying low-risk stocks are hoping for equity-like returns with a reduced downside. These are two fundamentally different investment philosophies.
However, both approaches have resulted in similar portfolios over multiple years, which meant that investors that had exposure to both factors effectively doubled up on the same risk. Perhaps the relationship was spurious in the first place, but should be monitored going forward.
Despite the appealing name, Low Volatility can be as rough and scary as Value.
ABOUT THE AUTHOR
Nicolas Rabener is the Managing Director of FactorResearch, which provides quantitative solutions for factor investing. Previously he founded Jackdaw Capital, an award-winning quantitative investment manager focused on equity market neutral strategies. Before that Nicolas worked at GIC (Government of Singapore Investment Corporation) in London focused on real estate investments across the capital structure. He started his career working in investment banking at Citigroup in London and New York. Nicolas holds a Master of Finance from HHL Leipzig Graduate School of Management, is a CAIA charter holder, and enjoys endurance sports (100km Ultramarathon, Mont Blanc, Mount Kilimanjaro).