What’s Up with Low Vol Investing?
Benjamin M. Lavine, CFA, CAIA
Co-Chief Investment Officer, 3D/L Capital Management
Note: An edited version of this article was first published on ETF.com.
As equity markets, corporate credit, commodities, and cryptocurrencies reach new post-pandemic highs amidst prospects for global economic reflation, ‘Low Volatility’ style of investing seems to have been left by the wayside. Regardless of whether we’re seeing a shift from large caps to small caps and from ‘growth’ to ‘value’, as long as the style in question captures higher beta (or higher risk stocks), then it seems to matter little.
Whether it’s record issuance of SPACs, the outperformance of negative earning companies versus positive earners, or the frenzy around retail trading on platforms offering near limitless margin to trade call options and illiquid OTC stocks, the disdain for volatility protection can be summed up by Figure 1 which displays the cost of an equity index collar or the premiums paid for index put options versus call options, which has reached multi-decade low levels.
Figure 1 – Gaga for Call Options as the Cost of Equity Index Collars Reaches Multi-Decade Lows
Source: BofA Global Research via The Daily Shot
The appetite for lower volatility strategies has sunk down a memory hole along with August “Volmageddon” of 2019 (mentioned in “The Year Smart Beta Died?”) and the Brexit vote of June 2016, both periods of time where low volatility experienced significant outperformance only to revert once the market ‘crisis’ at the time had passed. Who wants lower volatility when the path for higher market returns has been made clear by an overly accommodative Federal Reserve willing to keep rates near the zero bound through 2023 and the Federal government about to pass a $1.9 trillion stimulus plan? In addition, lower volatility strategies tend to underperform during a period of rising interest rates as we noted back in 2017 (“Min Vol ETFs Underperform When Rates Rise”).
We’re not suggesting that Low Volatility Investing is merely an investment fad that has turned from 2016 Brexit-driven darling to 2021 post-pandemic dud, but we merely point out that Low Volatility was the popular ‘flavor-of-the-day’ in 2016 along with currency-hedged investing (not as much discussion today with a much weaker U.S. dollar) just as ESG and Sustainability Investing are all what fund salespeople want to push in front of RIAs in the current period. Low Volatility has plenty of academic research documenting the anomaly when seen through risk-adjusted performance. Yet, you probably won’t hear much of it discussed in the current market environment.
Low Volatility’s unpopularity can be seen through a risk model lens where the ‘factor loadings’ to U.S. Momentum are at multi-year negative levels seen in Figures 2 and 3 for both Minimum Volatility (which captures low risk and low cross-correlations) and Low Volatility (pure low risk stocks) captured by USMV and SPLV, respectively. In these tables, we display the estimated sensitivity to various U.S. risk factors as defined by the Bloomberg U.S. Risk Model, color-coded with green representing the highest sensitivity and red the lowest sensitivity for each factor across the five-year period starting in March 2016. We highlight two specific periods: Current (2/15/2021) and the height of Brexit fears (6/30/2016).
Figure 2 – The Unpopularity of Minimum Volatility Investing as Seen Through a Risk Factor Lens (USMV)
Figure 3 – The Unpopularity of Low Volatility Investing as Seen Through a Risk Factor Lens (SPLV)
In addition, we show the factor loadings to both ‘Value’ and ‘Profitability’ suggesting that the fundamentals for Low Volatility look attractive on both a valuation and quality basis relative to recent history. Finally, we display the sensitivity to ‘Volatility’ itself where the current period demonstrates just how low ‘Low Volatility’ has gotten. Low Volatility may be out of favor, but it still reflects a higher quality investment style with one of the lowest risk profiles versus recent history.
The current risk profile of Low Volatility investing appears to be one of those Seinfeldian matzoh balls that looks too good to be true. One would be investing against the tidal appetite for high-risk reflationary assets, but Low Volatility is priced for peak euphoria rather than peak panic.
At the time of this writing, 3D held positions in USMV and SPLV. The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future. It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy. It is for informational purposes only. The above statistics, data, anecdotes, and opinions of others are assumed to be true and accurate however 3D/L Capital Management does not warrant the accuracy of any of these. There is also no assurance that any of the above are all inclusive or complete.
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By: Benjamin Lavine