Are low-volatility strategies just value investing in disguise?

Exchange-traded funds (ETFs) focused on low-volatility stocks have been popular with investors worried about global economic uncertainty and equity valuations. Yet it’s important for investors to understand exactly what they’re getting—and not getting—with low-volatility strategies. 

Are low-volatility strategies just value investing in disguise?

Although single-factor ETFs that focus only on low-volatility stocks are designed to limit drawdowns and overall volatility, academic research posits that low-volatility strategies will actually underperform the market over long periods. When low-volatility ETFs do outperform, it may be due to an emphasis on rate-sensitive sectors, or because of an overlap with other factors such as value that have long-term performance premiums. It’s important to remember, though, that low-volatility approaches and value investing aren’t the same thing, even though they may perform similarly at times.

The low-volatility anomaly

Low volatility is often included as a factor of a stock’s expected return, along with other key characteristics such as size, value, and profitability. However, Dimensional Fund Advisors, the subadvisor for John Hancock Multifactor ETFs, believes low-volatility strategies should have lower expected returns than the market.¹ 

Dimensional notes that low-volatility strategies have performed in line with the overall market in recent decades, but with less volatility, which has resulted in attractive risk-adjusted returns. This is sometimes called the “low-volatility anomaly.” Yet, going back to 1928, there have been long periods when low-volatility stocks underperformed the market, according to Dimensional’s research.

In fact, Dimensional found that outperformance and underperformance of low-volatility stocks were driven by other factors that have documented performance premiums: size, relative price (value), and profitability. For example, there have been times when low-volatility strategies outperformed because they overweighted value stocks and captured the value premium.² Still, low-volatility strategies have inconsistent exposure to value stocks,³ and they are sometimes overweight growth stocks. Therefore, investors probably shouldn’t count on low-volatility strategies having consistent exposure to the value premium.

Rate-sensitive sector tilts and turnover

There are many ways to construct low-volatility strategies using rules-based indexes with varying degrees of complexity. A simple approach is to focus on stocks that tend to fluctuate less than the market. For example, the S&P 500 Low Volatility Index selects the 100 least volatile stocks from the S&P 500 Index, then gives greater weightings to stocks with lower volatility as measured by standard deviation over the previous 12 months.⁴

Standard deviation measures a security’s tendency to fluctuate in price. Stocks with high volatility—such as a young, speculative biotech company—tend to see big swings. On the flip side, low volatility suggests an established company with a relatively stable business and stock price. Also, low volatility tends to persist in the short term, according to academic research.⁵ In other words, low volatility in past periods is a reasonably good indicator of low volatility in the future.

However, a relatively simple approach of selecting and weighting low-volatility stocks can lead to some quirky portfolio characteristics that investors should be aware of.

First, the performance of low-volatility strategies may be affected by their tilts to particular sectors. For example, the S&P 500 Low Volatility Index has nearly a quarter (24.3%) of its sector allocation in utilities, compared with just 3.3% for the S&P 500.⁶

A volatility index has bigger allocations to rate-sensitive sectors

This raises a larger issue that low-volatility stocks tend to be sensitive to interest rates.⁷ The performance of the S&P 500 Low Volatility Index has benefited from its overweights to rate-sensitive utilities and real-estate stocks over the past year with 10-year U.S. Treasury yields falling from about 3.25% to about 1.5% currently.

Rate-sensitive real estate and utilities are top-performing sectors

Finally, from a portfolio implementation perspective, low-volatility strategies that rebalance quarterly can have significant turnover, and those transaction costs and potential tax implications can make them more expensive to manage.⁸

Know what you own

It’s easy to understand why low-volatility ETFs appeal to investors who want some built-in downside protection for their equity exposure. And the evidence suggests that low-volatility strategies generally deliver on their promise of being less volatile than the market. As a result, over longer periods, they may lose less when the market falls, but may lag during strong bull markets.

But the recent outperformance of low-volatility strategies may cause some investors to think they’ve found the holy grail of investing: lower volatility and higher returns in all market cycles, resulting in superior risk-adjusted performance. However, investors should be cognizant that the recent performance of low-volatility stocks has been driven by sector overweights to rate-sensitive sectors in a falling-rate environment.

Also, over longer periods, the outperformance of low-volatility strategies may be due to overlap with the performance premiums of other factors such as value. And that’s why we think it’s important not to equate low-volatility strategies with value investing. 

 

 

1 “Low Volatility Strategies,” Dimensional Fund Advisors, August 2014. 2 “Research Brief: Low Volatility Strategies,” Dimensional Fund Advisors, August 2014. 3 “Low-Vol Strategies Are Not the Same as Value, Profitability,” Morningstar, 11/29/2018. 4 S&P 500 Low Volatility Index fact sheet, as of 7/31/2019, us.spindices.com. 5 “Low Volatility Strategies,” Dimensional Fund Advisors, August 2014. 6 S&P 500 Low Volatility Index and S&P 500 Index fact sheets, as of 7/31/2019, us.spindices.com. 7 “Does interest rate exposure explain the low-volatility anomaly?” Joost Driessen, Ivo Kuiper, and Robbert Beilo, September 2017. 8 “Examining Diversification in the Context of Low-Volatility Funds,” Morningstar.com, 12/19/2018.