The superior performance of low-volatility (and the related factor of low-beta) stocks was first documented in the 1970s – by Fischer Black (in 1972), among others – even before the size and value premiums were “discovered.” The low-volatility anomaly (i.e., lower risk stocks outperformed higher risk stocks) has been shown to exist in equity markets around the world. Interestingly, this finding is true not only for stocks but for bonds as well.
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The bear market of 2008 heightened investor interest in low-volatility investing. As one example, since inception in November 2011, the iShares Edge MSCI Minimum Volatility USA ETF (USMV) has gathered $26.7 billion in assets as of June 2019. Using data from Morningstar, the following table compares the performance of USMV to that of Vanguard S&P 500 Index Fund ETF (VOO). As you can see, in terms of risk-adjusted performance (the Sharpe ratio), USMV performed quite well.
November 2011-April 2019
| Annualized Return (%) | Standard Deviation | Sharpe Ratio | |
| USMV | 14.1 | 18.6 | 1.53 |
| VOO | 14.4 | 10.7 | 1.27 |
Before you jump on the low-volatility bandwagon, it’s important you understand that the research demonstrates that the performance of the low-volatility factor is actually well explained by exposure to other factors, and it is also highly regime dependent.
Exposure to other common factors explains returns to low volatility/low beta
Both Robert Novy-Marx’s 2016 study, “Understanding Defensive Equity,” and Eugene Fama and Kenneth French’s 2015 study, “Dissecting Anomalies with a Five-Factor Model,” argued that the low-volatility and low-beta anomalies are well explained by asset pricing models that include the newer factors of profitability and investment (in addition to market beta, size and value).
Stefano Ciliberti, Yves Lemperiere, Alexios Beveratos, Guillaume Simon, Laurent Laloux, Marc Potters and Jean-Philippe Bouchaud, authors of the 2017 paper “Deconstructing the Low-Vol Anomaly,” studied the factor on a global basis and found that once the common factors of value and profitability are controlled for, the performance of low volatility/low beta becomes insignificant. They concluded: “While the low vol(/low-β) effect is indeed compelling in equity markets, it is not a real diversifier in a factor driven portfolio that already has exposure to Value type strategies, in particular Earning-to-Price and Dividend-to-Price.”
In his 2012 paper, “Enhancing a Low-Volatility Strategy is Particularly Helpful When Generic Low Volatility is Expensive,” Pim van Vliet found that while, on average, low-volatility strategies tend to have exposure to the value factor, that exposure is time varying. The low-volatility factor spends about 62% of the time in a value regime and 38% of the time in a growth regime. The regime-shifting behavior affects the performance of low-volatility strategies. When low-volatility stocks have value exposure, they, on average, outperformed the market by 2.0%. However, when low-volatility stocks have growth exposure, they have underperformed by 1.4%, on average.
Luis Garcia-Feijóo, Lawrence Kochard, Rodney Sullivan and Peng Wang, authors of the 2015 study “Low-Volatility Cycles: The Influence of Valuation and Momentum on Low-Volatility Portfolios,” found that there was no alpha in a four-factor model except in extremely cheap low-volatility environments. This finding is important because, as you will see in the following table, the “curse of popularity” has changed its exposure to the value factor.
We’ll examine the current relative valuations of USMV, comparing them to those of the Vanguard Value Index Fund (VIVAX) and the DFA U.S. Large Cap Value Fund (DFLVX). Data is from Morningstar as of May 29, 2019.
| Price-to-Earnings (P/E) | Price-to-Book (P/B) | |
| USMV | 19.8 | 3.1 |
| VIVAX | 14.1 | 2.1 |
| DFLVX | 12.3 | 1.6 |
While the research has found that low volatility has outperformed, that was only true while it was in the value regime, which it had been about two-thirds of the time. Clearly, low volatility is not in a value regime today, its P/E being 40% higher than that of VIVAX and 61% higher than that of DFLVX, and its P/B being 48% higher than that of VIVAX and 94% higher than that of DFLVX.
Read the full article here by Larry Swedroe, Advisor Perspectives
