Minimum volatility funds are spending an increased amount of time in the spotlight as investors seek modest returns without having to navigate through the eye of the market storm. When any investment style garners too much attention, it begs the question, does it open itself to 'herding risk' as stocks become too high priced?
BlackRock's (NYSE:BLK) February 2016 report provides some interesting statistics to mull over:
- "Minimum volatility equity products have seen robust growth since their advent in 2011, with total AUM growing more than five fold since 2012, and with $5.3bn in year-to-date flows in 2016, minimum volatility equity products are on record pace for asset gathering."
The problem with this flood of new money is that it can create a momentum-like effect, which may encourage even more investors to jump aboard… and valuations rise even further. At some point, investors will jump ship and those left behind will have a losing strategy. Maybe. But only if we can show that low volatility stocks are becoming ridiculously overvalued.
A Look at Valuation
Let's examine a couple of charts which will highlight the valuation concern. The first chart will represent the average price-to-book ratio of low Beta stocks in the S&P 500 index. My 'low volatility' portfolio is simply the bottom 25% of the index when sorting according to Beta.
Yup. Looks like high valuation compared to the historical average. Time to cut bait and run. Or is it? Let's go a little deeper than this - shall we? The next chart will look at the net average price-to-book (p/b) ratio. This will compare our 'low volatility' portfolio to the entire S&P 500 index since 1999. The chart represents the p/b ratio of the 'low volatility' portfolio minus the p/b ratio of the market.
Well, let me go on record as saying that when we look at relative valuation of the low volatility portfolio, it doesn't look nearly so Chicken Little. There are times when the relative price-to-book ratio is significantly higher, but this isn't one of those times.
But there are other reasons why charts such as these still do not tell the whole valuation picture and a shift in valuation does not necessarily mean a change in risk. Why?
Valuation vs. Price Change
It is important that we don't confuse falling relative valuations with falling prices.
- When prices fall, you have a capital loss. When prices rise, you have a capital gain.
- Falling valuations do not necessarily mean capital losses and rising valuations do not necessarily mean capital gains.
For example, suppose a couple doubles their asset value but the share price increases by 50%. Valuations are down but prices are up.
As well, we are comparing low volatility valuation to the market. Assume all stocks in the market increase share price by 100%. Further assume that only low volatility stocks increase asset value. While all stocks receive the same capital gains, low volatility stocks are going through a valuation compression relative to the market.
When people say that low volatility stocks are overvalued and are suggesting that share prices will plummet as valuations revert to the mean, they may be making some unfair assumptions.
The chart below shows one period where volatility compressed between March 2009 and February 2011.
During this rapid compression of valuation, the low beta strategy underperformed by 2.5% annually. That being said, look at the Alpha or the risk-adjusted return, which is 8% higher. This is because the returns were generated with a whole lot less up and down motion.
But perhaps the most extreme example was during the dot-com boom. Who wanted to invest in boring low volatility when millionaires were being made trading highly volatile tech stocks? If I cherry-pick the horrors of low volatility investing, we get this chart from January 1999 to January 2000.
Over the next couple of months, the low volatility strategy did drop an additional 10%. I did not include that because relative valuation to the market was improving. The biggest loss came as valuations were increasing - oddly enough.
It might be better to look at the entire investment period to get the sense of the low beta strategy since 1999. This screen holds 125 lower beta stocks in the S&P 500 index since 1999 with 4-week rebalancing.
Stock Valuation Vs. Portfolio Valuation
It must not be overlooked that we are talking about an increase of valuation in a portfolio of stocks - not an increase in a single stock. The difference is vast, especially since stocks move in and out of our portfolio.
To illustrate, suppose I have a single-stock portfolio. I own the Clorox Company (NYSE:CLX), but later switch it out with Procter & Gamble (NYSE:PG). My portfolio valuation dive-bombs as CLX has a p/b ratio of 84 while PG has a p/b ratio less than 4. While my portfolio went through major valuation compression, the individual stocks did not. Portfolio valuation may change simply because stocks are replaced and not because the held stocks have some massive shift in valuation.
The drop of price-to-book ratio during 2009-2011 in the low volatility portfolio was partially due to a change in sector weights.
- In 2009, 13 out of 125 stocks were Utilities. The average price to book ratio was 1.24
- In 2011, 26 out of 125 stocks were Utilities. The average price to book ratio was 1.52
During the valuation compression, Utility stocks actually saw valuation increase on a stock-by-stock basis. Yet, portfolio valuation dropped because the total number of Utility stocks increased.
How Much Is That Doggie in the Window?
If low volatility stocks are becoming overvalued, you would naturally expect that a low volatility portfolio would see an exodus of value stocks.
To test this, I used the tools at Portfolio123. They have a pre-defined value ranking system that gives individual stocks a relative score between 0-100. The value ranking factors are:
- Price to earnings ratio
- Price to sales ratio
- Forward price to earnings ratio
- PEG ratio
- Price to free cash flow ratio
- Price to book ratio
My test has two steps.
- Have a low volatility portfolio of 125 stocks
- Record how many of these stocks have a value ranking of 50/100 or more
The number of value stocks in my low beta portfolio have been steadily increasing over time. On a stock-by-stock basis, this strategy is tilting toward value - not away from it.
My Highly Volatile Conclusion of Potential Value
What does all of this mean? It means you should do your own due diligence. Don't jump onto the low volatility bandwagon just because someone whom you assume knows more tell you it's a good idea. Don't jump off the bandwagon because someone shows you one scary chart and says that all the underlying stocks are increasing in value and share prices will collapse. Be skeptical - even of this article - I am only human.
Don't assume that low volatility means value and that high volatility equates a high growth stock. Facebook (NASDAQ:FB) doesn't have high beta. Nor does Essex Property Trust (NYSE:ESS). Gilead Sciences (NASDAQ:GILD) has a beta number in line with the market. And some investors consider these stocks to be S&P 500 growth picks.
My personal belief? I like the idea of low volatility. It is an implication of stability. But I do not read too much into measures like beta. Volatility represents how the equity is being traded and says nothing about the stability of the company, its earnings or its future prospects. Volatility is a measure of change, unsuredness and unexpected surprises. And there are many ways to measure volatility - beta might not be the best method. Still, if I am given a choice between two similar products, my preference will often be the one with lower beta. But that's just me.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.