The low volatility anomaly [1] has proved incredibly popular in recent years. Investors have moved billions into low volatility funds that dangle a juicy carrot – the potential to earn superior risk adjusted returns [2].
Historically, low volatility has beaten the market while exposing investors to less risk than the market portfolio.
Yet while other return premiums like value [3] and momentum [4] enjoy widespread support among theorists and empiricists, low volatility has taken the kind of credibility battering that’s normally reserved for the tooth fairy.
[5]
The evidence mounts
The major problem is that much of low volatility’s good run may be due to the historical quirk of a relentless 30-year decline in interest rates – a streak that can hardly be counted on in the foreseeable future.
What’s more, the popularity of low volatility funds over the past few years has led to a spike in valuations in the relevant shares – the perfect conditions for a long period of underperformance.
Passive investing champion Larry Swedroe has written extensively on the difficulties [6] that could beset low volatility investors in the future.
He cites evidence that past success has relied upon exposure to large, stable, high-yielding value companies, as well as high concentrations in the utility and non-durable goods sectors.
Such firms are known for loading up on debt. Such debt became cheaper as interest rates fell over the decades, which boosted the performance of those companies and by extension low volatility strategies.
If real interest rates rise though, then these firms may well suffer falls in price in a similar way to long-term bonds.
Over valued
The historical characteristics of low-volatility shares might also suggest that a low volatility tracker could be a good way to gain exposure to the value premium, though such trackers haven’t yet been around long enough for us to tell.
But there’s already evidence [7] that stable, large cap value firms could have lower expected returns than distressed small value companies teetering on the edge of extinction. That could indicate you won’t get similar rewards from low-volatility as you would from a true value fund because you’re not taking the same risks.
Plus if investing in low volatility in practice means betting big on just a couple of sectors (such as utilities and healthcare) then there’s no reason to believe that this will continue to pay off in the future. No one’s ever found a sector premium.
It all suggests to me that if you want a less risky way to pursue the value premium [3], you’d be better off investing in a value fund [8] combined with a UK Government bond fund to achieve the same result: market-like expected returns at a lower risk.
This way you’d also benefit from the low correlation between equities and government bonds.
Another danger with low volatility strategies has been identified by Erik Knutzen, author of the study, Pursuing the Low Volatility Anomaly [9].
Knutzen shows that the money flooding into low volatility equities had inflated their prices to a 22% premium by 2012, concluding:
Expensive valuation for low volatility stocks is consistent with their strong recent relative performance and may also indicate an impending period of sustained underperformance.
In fact, in order for the track record of low volatility stocks to become consistent with the expectations we described earlier as reasonable, this category may have to experience a lengthy period of sub-par returns.
Gulp.
Practical difficulties
Meanwhile the authors of the paper The Limits to Arbitrage and the Low-Volatility Anomaly [10] found that the low volatility premium may well persist in the data because it’s exceptionally difficult to capture in practice.
Once they factored in the real-world costs of executing a low volatility strategy (usually neglected by the academics), the authors discovered that most of the theoretical gains were wiped out.
They warn:
In short, our findings cast some doubt on the practical profitability of a low risk trading strategy.
Finally, in his paper Understanding Defensive Equity [11], Professor Robert Novy-Marx found that low volatility’s edge is explained by its bias against small, unprofitable growth equities, of the sort that have long proven toxic for investors. Novy-Marx demonstrates that the low volatility story does not hold up in other segments of the equity universe.
In other words, the significant outperformance of low volatility is restricted to small cap growth companies, whereas the normal, positive relationship between risk and reward is restored for small value and large cap equities.
Moreover, much of the theoretical success of low volatility strategies may well come from shorting these highly volatile and unprofitable small companies. That is something that is entirely feasible in the frictionless confines of an academic’s back-tested simulation, but which you won’t find on offer from any of the low volatility ETFs that we can actually invest in.
Novy-Marx concludes:
This is not to say that an individual would not have benefited from following a defensive strategy. Investors certainly would have profited from avoiding unprofitable small cap growth firms.
Defensive strategies are, however, an inefficient way to exploit these premia, which are better accessed directly.
Investing in value and profitability/quality funds would be one way to do this.
Take it steady,
The Accumulator