The Value of Low Volatility

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Beliavsky
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The Value of Low Volatility

Post by Beliavsky »

This paper finds that the low-volatility effect in stocks is not just a proxy for the value effect. The value premium has been negative for the last 10 years and also more recent time intervals, while low-volatility indices have done relatively well.

The Value of Low Volatility

David Blitz
Robeco Asset Management - Quantitative Strategies
February 10, 2016
Journal of Portfolio Management, Forthcoming

Abstract:
The evidence for the existence of a distinct low-volatility effect is mounting. However, implicit exposures to the Fama-French value factor (HML) seem to explain the performance of straightforward U.S. low-volatility strategies since 1963. In this paper I show that the value effect can neither explain the performance of large-cap low-volatility strategies pre-1963, nor post 1984, when the Fama-French value factor itself ceased to be effective in the large-cap segment of the market. Moreover, the performance of small-cap low-volatility strategies cannot be explained by the value effect during any period. Fama-MacBeth regressions support the existence of a low-volatility effect for every subsample. Based on these results and various other arguments I conclude that there exists a distinct low-volatility effect which cannot be explained by the value effect. The combined evidence even appears to be stronger for the low-volatility effect than for the value effect.

Number of Pages in PDF File: 17
Keywords: low volatility, low beta, betting against beta, value
JEL Classification: G11, G12, G14
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Re: The Value of Low Volatility

Post by larryswedroe »

There's a lot of research on low vol and off top of head they also have tended to have exposure to term risk--and rates have been falling of course, value and BETTING AGAINST BETA. Once you account for these THREE, not just one, it's gone, or subsumed. Now it still might be good thing because by using the strategy you are diversifying your sources of risk, IMO generally a good thing.
And now their popularity has converted what was once a value type strategy to much less of one, as valuations are now much higher.
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Re: The Value of Low Volatility

Post by steve r »

For 85 years, low volatility investing has lead to reduced risk and higher risk adjusted returns. Period. This fact has been written about now since the 1970s and the pattern continues. Moreover, I suspect that it is hard for this space to get crowded, as crowds increase volatility -- thus changing what the mix of the assets in a fund (as opposed to chasing tech companies, small cap value companies, growth companies, etc.)

The peer reviewed paper suggests that this is different from the value effect. However, as pointed out by Larry -- it may explained jointly by multiple factors. This is an interesting academic exercise and debate, particularly for those who want a better explanation on the "how" and "why."

To me, the simpler and clear explanation of low vol's success is the lottery effect (100 percent equities anyone?). It appears to me that even fund managers cannot avoid lotteries. I get why some are skeptical of the explanation (particularly the part about why fund managers are not immune).

Very good paper and comments thus far.
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Re: The Value of Low Volatility

Post by nisiprius »

To what extent is low volatility a persistent, robust, reliable intrinsic characteristic of a stock?

To what extent is past low volatility a sure indication of future low volatility?

Is "low volatility" actually an actionable strategy or is it just a sophisticated form of "chasing" something?

An awful lot of the factor stuff seems to me to be genuinely impressive in terms of identifying descriptive dimensions of behavior, but unless the factors are intrinsic, robust, and stable, it is explanation, not prediction. If they are not stable, one might as well identify a "high return" factor and choose to overweight "high return stocks."
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Re: The Value of Low Volatility

Post by larryswedroe »

Few thoughts
First, it is simple for low volatility to get crowded and it already has as I have shown, with valuations rising--they used to be more value type stocks but no more

Second, yes the research shows that low volatility does predict low volatility (IMO but not returns).

Third, there really isn't IMO much to low vol, it's really that HIGH vol stinks and should be avoided. The other quintiles don't have much if any difference in returns, and the differences aren't monotonic as they are with value and size.

So bottom line is don't need IMO to invest in low vol, just avoid high vol

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Re: The Value of Low Volatility

Post by Beliavsky »

nisiprius wrote:Is "low volatility" actually an actionable strategy or is it just a sophisticated form of "chasing" something?
There are low-volatility and minimum portfolio volatility stock funds you can invest in, even one from Vanguard (VMFVX), and they have done pretty well overall, so it is obviously "actionable". Of course, future performance is unknown, just at the future level of the equity risk premium is unknown.
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Re: The Value of Low Volatility

Post by Beliavsky »

Bitten But Not Mauled, Low Volatility ETFs Attract Fans
Bloomberg
by Eric Balchunas
February 12, 2016 — 7:00 AM EST
So far, in this newly christened bear market, the ETFs have been living up to their promise. They are down a lot less than the markets as a whole. The table below shows the five largest low-volatility ETFs, all of which have over a billion dollars in assets.

USMV and SPLV are outpacing the S&P 500 by 6.5 percentage points and 6.8 percentage points, respectively. Such protection from the worst of the downside explains why the universe of low-volatility ETFs has doubled in size over the past two years, from $11 billion in assets to $27 billion.
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Re: The Value of Low Volatility

Post by nisiprius »

larryswedroe wrote:Third, there really isn't IMO much to low vol, it's really that HIGH vol stinks and should be avoided. The other quintiles don't have much if any difference in returns, and the differences aren't monotonic as they are with value and size. So bottom line is don't need IMO to invest in low vol, just avoid high vol...
Interesting, noted.
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Re: The Value of Low Volatility

Post by Erwin »

I have been a converter since early 2015 after I read all the research I could find.
Thus, I have invested exclusively in low volatility equity ETFs. My global equity diversification is: 45% USMV (instead of SPY), 45% EFAV (instead of EFA), 10% EEMV (instead of EEM).
And now during the current market fall I cannot be happier.
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Re: The Value of Low Volatility

Post by larryswedroe »

Re low vol perfomance, As I said low vol predicts low vol. So not surprising. But you can get there by just having lower equity allocation and screening out the bad stuff and get better returns IMO. I'd add that now you are owning relatively high priced stuff with term risk.
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Re: The Value of Low Volatility

Post by steve r »

mpt follower wrote:I have been a converter since early 2015 after I read all the research I could find.
Thus, I have invested exclusively in low volatility equity ETFs. My global equity diversification is: 45% USMV (instead of SPY), 45% EFAV (instead of EFA), 10% EEMV (instead of EEM).
And now during the current market fall I cannot be happier.
I think that makes two of us! (at least on Bogleheads). For all the talk of the space being crowded, it is not crowed by those on this site.

I continue to read every BH posting on this topic and have not seen a reason to change. I too preferred minimum variance over the low vol offerings which are too sector concentrated. I was in ACWV years ago, but switched to VMNVX when it came out and also "cannot be happier." I am exclusive except for my work related options (about half portfolio).
"Owning the stock market over the long term is a winner's game. Attempting to beat the market is a loser's game. ..Don't look for the needle in the haystack. Just buy the haystack." Jack Bogle
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Re: The Value of Low Volatility

Post by larryswedroe »

steve R
Just check the p/e ratios of the low vol funds and compare them to value funds of say DFA. They used to be quite similar, no more, at last I checked
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Re: The Value of Low Volatility

Post by 691175002 »

If you run a backtest on low-vol you will notice its outperformance really kicks in once the ETFs came out; and the overall performance has been dramatically buoyed by inflows into those categories and related index ETFs (Such as large-cap, dividend, or even the S&P500).

I think that low-vol will have a hard time matching its historical performance (which has been genuinely spectacular) but you aren't taking a huge risk either.
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Re: The Value of Low Volatility

Post by steve r »

larryswedroe wrote:steve R
Just check the p/e ratios of the low vol funds and compare them to value funds of say DFA. They used to be quite similar, no more, at last I checked
Larry
691175002 wrote:If you run a backtest on low-vol you will notice its outperformance really kicks in once the ETFs came out; and the overall performance has been dramatically buoyed by inflows into those categories and related index ETFs (Such as large-cap, dividend, or even the S&P500).

I think that low-vol will have a hard time matching its historical performance (which has been genuinely spectacular) but you aren't taking a huge risk either.
Per wiki and M* ... for ACWV the last two years have been good. But the fund under performed the first two years. This space historically underperforms during strong bull markets and plays catch up other times. I accept this under performance as fact (the catch up part other times may or may not happen).

ACWV has NEVER been a value fund. The peer reviewed article the OP sites shows value and low vol are not related. YES, there are other studies that show differently. I guess that is what makes this discussion of interest.

The PE ratio is dully noted (THANKS), but it is still far from the PE of the growth index. I guess it is being suggested that the PE is a result of performance chasing in the low vol space ... but it strikes me that a more plausible explanation (and who knows) is that the value space has been more volatile lately (with dividend plays and the like). Something the low vol funds and myself would want to ignore. Only time will tell.

http://portfolios.morningstar.com/fund/ ... ture=en_US
"Owning the stock market over the long term is a winner's game. Attempting to beat the market is a loser's game. ..Don't look for the needle in the haystack. Just buy the haystack." Jack Bogle
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Re: The Value of Low Volatility

Post by larryswedroe »

691175002
Keep in mind that low volatility has been shown to have exposure to term risk, which certainly has been paying off over not only recent years but basically since early 80s. No prediction from me but the risk adjusted odds of term risk paying off certainly are a hell of a lot worse than they were 35 years ago. (:-))

Here's some research

Ronnie Shah, author of the study “Understanding Low Volatility Strategies: Minimum Variance,” found that for the period 1973-2011, the low beta strategy has exposure to term risk — the “loading factor” (degree of exposure) was .09, and it’s statistically significant (tstat of 2.6).
As further evidence, the authors of the 2013 study “A Study of Low Volatility Portfolio Construction Methods,” found a 0.2 correlation between the BAB (betting against beta) factor and the duration factor.


When examining the anomaly, Robert Novy-Marx, in his September 2014 paper “Understanding Defensive Equity,” which covered the period 1968-2013, found that when ranking stocks by quintiles by either volatility or beta the highest quintile stocks dramatically underperform while the performance of the other four quintiles are very similar and market-like. http://rnm.simon.rochester.edu/research/UDE.pdf

And the following is from a bit of research I did a while ago, but not that long ago:

We can also see how the increased popularity of the low volatility strategies has changed their very nature by looking at how the loading factors have shifted over time. We’ll take a look at the results of regression analysis on the SPLV and USMV. Using the tool provided by the website http://www.portfoliovisualizer.com/factor-analysis, we’ll begin with a look at SPLV. The inception date of this ETF was May 5, 2011. And data is available through October 2014. We’ll split the 41-month period into two roughly equal halves, June 2011-February 2013 and March 2013-October 2014. The regressions included the factors of beta, size, value, momentum, quality, low beta and the two bond factors of term and default. In the first half of the period SPLV had a loading on the value factor of 0.78. For the second half of the period the value loading was -0.07. In other words, SPLV went from having a very high loading on the value factor to now having a slight loading on growth.

The inception date for USMV was the October 18, 2011. Thus, we’ll split the 36-month period into two equal 18-month periods, November 2011-April 2013 and May 2013-October 2014. For the first half of the period, the value loading was 0.56. In the second half it was -0.29. Once again, we see the same result — the very nature of the fund has shifted from a value oriented fund toward a growth oriented fund. In other words, the results of the regressions confirm what a simple look at the valuation metrics told us.

There’s a cliché in finance that success can sow the seeds of its own destruction. At the very least, investors in low volatility strategies should be aware that the flow of cash into the strategy has changed the very nature of the funds. While they may still be low volatility, they no longer look like value funds. And the lower exposure to the value premium means that they now have lower expected returns. In addition, it doesn’t seem likely that low volatility strategies will benefit in the future as they have in the past from their exposure to term risk. Forewarned is forearmed.

Larry
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Re: The Value of Low Volatility

Post by garlandwhizzer »

Cap weight index investors tend not to avoid Low Vol funds or efts because they are in a sense factor based. Likewise most factor investors, Larry being a good example, don't like them and prefer other factors. They argue that Low Vol is subsumed by other factors, or that its stocks have become too expensive, or that all that is necessary to get the benefits is to omit extremely high vol stocks. They also point out that all one has to do to replicate the risk/reward tradeoff of a Low Vol portfolio is to decrease equity exposure and increase bond exposure. Hence there seems to be no reason to invest in this area at all. There are many arguments against Low Vol investing including the fact that it makes no sense at all that lower risk should produce higher returns. Lower risk according to all standard economic theories, and to common sense as well, should produce lower, not higher, returns.

I am a bit sorry that this article by Blitz came out. When everyone else, factor enthusiasts and market weight types, amateurs and sages alike, argue against something I think it's time to take a hard look at buying it. I did and purchased a considerable position in Vanguard's Global Min Vol fund quite some time ago. Needless to say I am happy now that I did. Although since inception it has massively outperformed the comparable index, Total World Index, 8.3% this year alone, 19% in less than the 2 years of its existence, I'm not sure it will outperform long term. I'm not sure that any of the factors will outperform long term for that matter. What I am sure of is that Low Vol will outperform on a risk adjusted basis. No one argues otherwise looking at the data.

Some suggest that to achieve the same level of risk adjusted return all one needs to do is to decrease equity and increase bond exposure. A recent academic study looked at this question historically and concluded that in a balanced 60/40 or 50/50 cap weight portfolio shifting 20% from cap weight equity into Low Vol equity outperforms on a risk adjusted basis any amount of shifting cap weight equity into bonds in that same portfolio. Increasing bond exposure reduces portfolio volatility dramatically but it also reduces expected long term returns significantly. My addition of VMNFX, the Admiral shares, has reduced my overall portfolio volatility in these difficult times in the same way as if I had reduced equity and increased bonds to some extent.
However if and when the market turns around and goes up, if and when the economy improves and interest rates rise, my Low Vol equity will go up with it, perhaps not as dramatically as cap weight equity, but certainly better than bonds which will suffer declines in principal value as interest rates rise. Eventually in this rising tide of economic growth and increasing interest rates, the increased yields on bonds catch up with principal losses, but in the meantime, a span of years perhaps, it is expected to underperform Low Vol. I'm looking long term and over the next decade I expect positive real returns from the Low Vol portion of my equity portfolio and a smoother ride than with the cap weight portion. As for bonds I expect a good anchor in equity downturns but at the price of essentially zero real positive returns over the next decade or so.

I hope skepticism about Low Vol remains high and popularity relative to other factor approaches remains low. For those who would like to see Morningstar's take on Low Vol, I suggest you go to their website and access their video presentation, "A Compelling Global-Stock Fund for Risk-Averse Investors."

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Re: The Value of Low Volatility

Post by nedsaid »

Garland, I really enjoy your posts. I think you are right to go against the grain a bit.

The best time to go into a strategy is when it is unpopular and folks don't talk about it very much. There has been a lot of discussion in recent years about low-volatility and that alone made me reluctant to venture there. You did and that has worked out well for you. Too bad when too many papers get written about something that works good.

My guess would be that the lower volatility stocks would be heavy in consumer products. Stuff that you have to buy no matter what: food, toilet paper, Kleenex, soap, cleaning products, etc. What we used to call defensive stocks. I suppose the well run utilities would probably be in this category too. My further guess is that these are almost all dividend paying stocks as well. These would also tend to have slower earnings growth rates than the popular growth stocks. Am I correct?

Again, a good time to buy in would be when these type of stocks are not popular, that is during good economic times. People would be chasing the higher growth stocks and these "defensive" or "low volatility" stocks would be left in the dust during the good times. Not sure this is the best time to be chasing these right now. EVERYONE is worried about volatility right now so I would expect folks are piling into the "safe" stocks now.

My advice for near retirees wanting to pursue this strategy is to look for economic good times (if they ever get here), that is a boom. That would be a perfect time to buy these type of funds. In other words, buy in at a time when people aren't concerned about volatility.

I think this is a perfectly rational strategy to pursue but probably not right now.
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Re: The Value of Low Volatility

Post by stlutz »

A few notes:

--Historically, the biggest outperformance of low vol is course during down markets. It was a strategy that looked very good in the 2000s because there were two huge down markets during that time. When stocks are mostly going up, the strategy of course looks less attractive, as in 2012-2014.

--As long as USMV has been around at least, it has had a P/E multiple higher than the market. This isn't the case with longer historical backtests of course. Over time, the value loading of low. volatility has varied all over the pace. Larry implies that it's been the case that low-vol always = value until just a couple of years ago it suddenly switched. That's actually not the case.

--However, on average low vol has had a positive value loading. And that makes sense as value has generally (but now always) been less volatile that growth over time. If low. vol. loads on value, then value loads on low. vol.

--If your primary goal is maximum absolute return, it's probably better to focus on "mid vol" than "ow vol." If your goal is maxium risk-adjusted return, then low vol is a good bet.

--I don't buy the argument that there are oogles of money loading up on low volatility stocks. There are all of 2 low volatility ETFs that I'm aware of. Yes, they've added a lot of assets, but they are investing mostly in large cap stocks where there is capacity to absorb additional investment. If there was this gigantic demand for this strategy, there would be more such ETFs and funds than there are. Just as growth and value tend to balance themselves out in terms of AUM, low vol is balanced out by interest in FANG stocks etc. There isn't a lot of talk on Fast Money about Johnson & Johnson.

--The higher multiple of low volatility stocks isn't really a function of low vol being overvalued but more of value stocks (i.e energy and financials) being a lot more volatile of late. USMV isn't loading up on beaten-down energy names. Does energy and financials being way down mean that the rest of market is "overpriced"? I don't think so--those two sectors are down because they should be down--they have exhibited a lot of realized risk.
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Re: The Value of Low Volatility

Post by Robert T »

.
1. Simply (only) factor exposure: Exposure to market, size, value, momentum and quality explain 92 percent of the historical return variation of the MSCI US minimum volatility index (recently being tracked by USMV). The residual alpha = -0.01 [using the full time period available for the series which extends back to mid-1988]. And as noted above, it also has positive term exposure.
viewtopic.php?p=2206354#p2206354

2. Time varying factor exposure: There has been some variation in factor loads over time. For example over the last three decadal periods, the value load has ranged from -0.03 to +0.18 (with a positive value load of the full period); the momentum load has ranged from 0 to +0.13; and the quality load has ranged from +0.11 to +0.27. viewtopic.php?p=2208518#p2208518 There is some evidence of time-varying factor exposure over longer periods https://www.aqr.com/library/journal-art ... portfolios …and ”once the well-known cross-sectional factors of style and momentum are controlled for, alphas and information ratios for our two long–short portfolio strategies decline.”
  • MSCI US minimum volatility (being tracked recently by USMV).

    Value load
    1990s = +0.18
    2000s = +0.26
    2010s = -0.03
    Full = +0.19

    Momentum load
    1990s = +0.00
    2000s = +0.02
    2010s = +0.13
    Full = +0.01

    Quality load
    1990s = +0.15
    2000s = +0.11
    2010s = +0.27
    Full = +0.19
3. Time varying exposure to value, momentum, and quality through MSCI minimum volatility, has not added value beyond a more 'static' exposure. For example from 1999-2014 the MSCI ACWI Minimum Volatility series has an annualized return of 7.5% with a 2008 downside of -25.6. A 69% MSCI ACWI Diversified Multifactor Index: 31% 5-year T-notes had the same 2008 downside of -25.6, but with a 1.1% higher annualized return (8.6%). viewtopic.php?p=2544900#p2544900

I find it interesting that some folks seem are happy to hold minimum volatility funds, but at the same time seem to shun value and momentum – when the former is just a combination of the latter (+quality) – they are standing on the same ground (just be aware of it). It is a tilt away from the market to value, momentum, and quality, with lower beta. Lower beta is the equivalent of adding bonds (by definition of the regression used to estimate the beta coefficient], and in the case of min. vol., with some term exposure. And recent strong performance of minimum volatility has been driven, in part, by momentum exposure. For example the iShares MSCI US momentum returns in 2014 and 2015 were +14.6% and +8.9% respectively.

FWIW - I like exposure to value, momentum, and quality (and term exposure), so I like minimum volatility (relative to market exposure), but don’t think it adds value beyond a more ‘static’ exposure/allocation to these factors as the above evidence suggests.

Just my take.

Robert
.
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Re: The Value of Low Volatility

Post by Beliavsky »

--I don't buy the argument that there are oogles of money loading up on low volatility stocks. There are all of 2 low volatility ETFs that I'm aware of. Yes, they've added a lot of assets, but they are investing mostly in large cap stocks where there is capacity to absorb additional investment. If there was this gigantic demand for this strategy, there would be more such ETFs and funds than there are. Just as growth and value tend to balance themselves out in terms of AUM, low vol is balanced out by interest in FANG stocks etc. There isn't a lot of talk on Fast Money about Johnson & Johnson.
The assets in low volatility ETFs are one number to look at but do not represent the total amount of money devoted to the strategy. For example, Acadian Asset Management is one firm that manages low volatility strategies http://www.acadian-asset.com/Strategies ... ducts.aspx but does not offer an ETF. There are lots of quantitative equity shops, and I would not be surprised if the majority of them use low volatility as one of the factors in their model. The majority probably do use portfolio optimization tools as well, but perhaps to minimize tracking error rather than overall volatility.
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Re: The Value of Low Volatility

Post by Clive »

Volatility clusters, stocks that have risen a lot quickly can fall a lot quickly; Stocks that have fallen a lot quickly can rebound quickly. Compare a pool of more mundane/bland (lower volatility) stocks reward to that of a pool of volatile stocks and investors price both to collectively provide comparable rewards (otherwise there'd be a bias towards holding the more consistently rewarding). Similar rewards but with one having achieved that reward with higher volatility when volatility is considered as a 'risk' and the higher volatility pool has a lower Sharpe Ratio (which is fundamentally reward / volatility). In isolation higher volatility looks to be the less best choice, when blended with other assets/styles however and blending high and low volatility combined with periodic rebalancing will yield a higher reward that 'compensates' for the difference.

Real world example - as a US alien (UK) its better for me to hold more volatile low/no dividend US stocks and avoid/reduce 30% US dividend withholding tax than it is to hold average/high dividend yield stocks and pay a higher amount of withholding tax. Combined/blended with more stable lower taxed domestic UK assets and rebalancing yields comparable gross rewards more tax efficiently. Volatility 'trading capital gains' (that occur naturally through rebalancing) in effect replace more tax costly dividends. Similar gross reward, higher net reward. On a assumption of a 4% longer term historic dividend yield and 30% dividend withholding tax = 1.2%. i.e. I can accept higher volatility/lower reward from US non-dividend stocks in order to achieve overall similar portfolio wide reward (and volatility (risk)).

In the absence of costs and taxation effects - measures are incomplete and will 'reveal' apparent (but incomplete) characteristics/conclusions.
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Re: The Value of Low Volatility

Post by garlandwhizzer »

Nedsaid, thanks for your kind comments. You are right, I believe, that we're now in a market cycle (stuck in neutral or reverse) when Low Vol gains popularity. VMVFX clearly has outperformed global market indexes since its inception and this alone will draw in investment dollars. I do have concerns about this. In down markets Low Vol is expected to outperform. In exuberant bull markets it is expected to underperform. In middling markets its performance depends on its degree of upside action capture versus its downside action loss, dependent to some degree on stock selection but probably about the same as the market return. If I believed that we're currently or shortly to be in an exuberant bull market I wouldn't be there. If and when such a market returns or I anticipate it strongly in the near future based on macroeconomic fundamentals, I plan to move from Low Vol back into broad market indexes. I confess that this is market timing and I may screw it up, but in the meantime I expect to earn not necessarily a market beating return but very likely a better risk adjusted return than a comparable market portfolio. That, at least, is how I see it.

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Re: The Value of Low Volatility

Post by nedsaid »

Garland, this stuff is hard to get just right. Sounds to me like you are doing just fine. Holding a Low Volatility Fund or ETF would allow you to hold a bit higher equity allocation. This is a good idea worthy of consideration. I wouldn't buy such a fund now but if I owned such a fund, I sure wouldn't sell it.
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Re: The Value of Low Volatility

Post by stlutz »

I find it interesting that some folks seem are happy to hold minimum volatility funds, but at the same time seem to shun value and momentum – when the former is just a combination of the latter (+quality) – they are standing on the same ground (just be aware of it). It is a tilt away from the market to value, momentum, and quality, with lower beta. Lower beta is the equivalent of adding bonds
Not sure who "some folks" are, but in the context of this forum, I'm guessing you might be referencing me since I have posted in most of the discussions we have on low. vol. :happy

Looking at the broader literature from people who do this for a living, I haven't seen any promoter of low. vol. dismiss value, momentum, quality etc. Most everyone who practices low volatility stock picking also utilize the broader range of factors that are often discussed. I do see the opposite quite a bit--folks who promote other factors but dismiss low vol as basically worthless, or "just a combination of other factors". I think Ronnie Shah's paper (DFA) really started it. On this forum, Larry S. writes in the same vein.

In these threads, I do tend to promote the low. vol. concept while expressing more skepticism on some of the value discussions. But that is based on more on what I can contribute to the discussion than a dissertation of my own views. So, let me just state my own views concisely, both with regard to practical and theoretical matters.

a) Practical: For someone who is relatively early in the accumulation phase and may have a portfolio of 85% stocks, there isn't really much point in low volatility stocks. If you want less volatility, add more bonds.

For someone who is approaching or in the distribution phase, low volatility stocks make more sense. For these people, standard deviation is a much deeper risk than it is for someone who is 28 years old. Having a stock portfolio that declines 20% in a bear market as opposed to 30% can add many years to the lifetime of their portfolio.

Why not just add more bonds? Well, the big bond returns are in the past. If you are already 50%+ in bonds, I'm not sure that adding more bonds is an improvement. It's worth remembering that the low volatility effect in stocks was robust in the 60s and 70s when rates were consistently rising and the term premium was low or negative. As you have noted, low vol's correlation to other factors does vary over time, so adding low vol really isn't the same thing as just adding more bonds.

It may be true that one can come up with a combination of 5 other factors that if used in the exact correct percentages will replicate the results of a low volatility portfolio. But if low volatility stocks are what you want, why not just make it easier and buy those?

b) Theoretical: I think the frequent opposition to the low vol effect has more to do with philosophy than anything. For the 3 factor crowd, there was a very simple rubric that they lived by: a) higher risk = higher expected return; b) value and small have outperformed historically. c) Therefore value and smallcap stocks are more risky. d) Because they are riskier, one should expect that they will outperform in the future.

Obviously, some of the “newer” factors like low vol. (which is actually quite old) and quality throw cold water on this construction. I am interested in the whole low vol discussion simply because it does require a reassessment of how markets work. The more risk=more expected return framework was always based more on a belief on the part of some professors as to how markets should work as opposed to observing how they actually do work. The reality is that the relationship between risk and return is much more complex than standard financial theory allows for. And ultimately, that complexity is what I'm interested in exploring.

And so, I don't dismiss value (I personally have a lot more invested in value funds than low vol funds); I do dismiss the notion that value is all but guaranteed to outperform in the future because it is more risky. Actually, I think it's worth considering that value's past outperformance may be more related to those stocks having lower risk, not higher.

I don't dismiss the value effect. I do dismiss the traditional explanations of historical value outperformance, mainly because of what low vol has shown us about the ambiguous relationship between risk and return.
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Re: The Value of Low Volatility

Post by roflwaffle »

Beliavsky wrote:
nisiprius wrote:Is "low volatility" actually an actionable strategy or is it just a sophisticated form of "chasing" something?
There are low-volatility and minimum portfolio volatility stock funds you can invest in, even one from Vanguard (VMFVX), and they have done pretty well overall, so it is obviously "actionable". Of course, future performance is unknown, just at the future level of the equity risk premium is unknown.
While VMFVX has only been around for 5+ years, how much of a reduction in volatility will you see compared to something that's potentially more volatile? Eyeballing the performance over the last five years, I'm not sure why you would see a similar ride up with both and not see a similar ride down with both.

https://www.google.com/finance?q=MUTF:V ... DC_1EQ4LEN
https://www.google.com/finance?q=MUTF:VISVX

Granted, this might pan out over the course of multiple decades instead half a decade, but if it takes that long to show up, I don't see that as being an advantage. Especially if earnings from the higher volatility fund are sufficient to place it's local minimum near the value of the lower volatility fund's minimum. In that context, the only slight advantage is in the near term.
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Re: The Value of Low Volatility

Post by alpenglow »

I know there is a separate thread on this article, but I think it is worth mentioning here too.

http://www.researchaffiliates.com/Our%2 ... Wrong.aspx

RA's findings fit with Larry's comments on overvaluation high valuation in low vol.
Last edited by alpenglow on Mon Feb 15, 2016 1:01 pm, edited 3 times in total.
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Re: The Value of Low Volatility

Post by larryswedroe »

alpenglow
I wouldn't say overvaluation, just high valuation meaning lower expected returns.
Larry
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Re: The Value of Low Volatility

Post by alpenglow »

Very true. Sorry to put words in your mouth.
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Re: The Value of Low Volatility

Post by trope »

steve r wrote: To me, the simpler and clear explanation of low vol's success is the lottery effect (100 percent equities anyone?). It appears to me that even fund managers cannot avoid lotteries. I get why some are skeptical of the explanation (particularly the part about why fund managers are not immune).
What is the lottery effect?

And what is term risk? Has been mentioned a couple times in this thread.
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Re: The Value of Low Volatility

Post by larryswedroe »

trope
Lottery effect is well known that retail investors especially have a strong preference for investments with distribution of returns that looks like lottery ticket, positive skew with excess kurtosis (long but thin right tail, with poor mean return). That preference and limits to arbitrage (high costs and fear of margin) prevent sophisticated investors from correcting mispricings (from pure economic standpoint.

TERM risk is duration risk, risk of rising rates

And low volatility stocks have significant exposure, logically as they are more bond like with more stable earnings, to term risk and thus have benefited greatly from long term secular trend in lower rates. Now I am 100% confident virtually no retail investors are aware of this, they have just been attracted by high past relative returns. Also if you want to get really worried check out the value metrics of the largest ETF USMV --note how growthy the stocks now are, with p/b more than 2x DFA LV fund, yet in prior times, before they became popular, low vol stocks used to be value stocks.
Now they are at bubbly levels even for growth stocks, and well above TSM valuations. Now that likely tells you nothing about tomorrow's returns, though I do think it provides us information about longer term returns. Buyer beware

Note I'll have blog post on this in near future, already written and in queue, and it's covered in new book which is almost done. Another few days and we'll go into publication mode and hope to have out by year end.

Larry
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Re: The Value of Low Volatility

Post by trope »

Thanks, very informative. btw, I just finished reading your book on black swans.
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Re: The Value of Low Volatility

Post by freyj6 »

Lots of great posts here.

I agree that some of the low-volatility indexes are generally worth having on a risk-adjusted basis. It seems that a 100% allocation to low-volatility stocks will general outperform an 80/20 with around the same risk.

At current levels with all the yield chasing and high valuations, however, I don't know.

Personally I held around 15% VDC for the last year and was obviously quite happy with it, but I recently became uncomfortable with the valuations and swapped it out at 142. Will the trend continue? Who knows. But low-vol is starting to feel like tech stocks at P/E 30 in the late 90s.

That being said, I will likely resume that 10 or 15% allocation if valuations normalize.

Cheers
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Re: The Value of Low Volatility

Post by larryswedroe »

frey
I would NOT rely on historical returns for low volatility for the two main reasons I cited, the high returns can be at least partly attributed to exposure to term and value factors, and you cannot get the big benefit it has had from TERM, and it could be big negative, and there is now negative exposure to value premium.
Also note that most of the benefit really comes from not buying high volatility, not buying low vol.
So most people really don't understand how the premium has come about.

Trope
Hope you found the Black Swan book of value.

Best wishes
Larry
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Re: The Value of Low Volatility

Post by freyj6 »

Thanks Larry. That makes sense, and I'll look forward to your blog post.

I certainly don't plan on jumping back in any time soon and I was happy to quit while ahead on this one. But if the staples sector falls dramatically out of favor, say, 5 years from now, I'd happily jump back in. That being said, I appreciate you describing how falling interest rates play into outperformance here -- I wasn't aware of that.

To digress slightly, like REITs, I think that a few of the other sectors have attractive diversification benefits. I don't currently hold any sector tilts, but I'm open to the idea. I'd consider a REIT allocation if valuations came down dramatically, and a small allocation to something like VDE seems reasonable as an inflation hedge.

:sharebeer
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Re: The Value of Low Volatility

Post by stlutz »

And low volatility stocks have significant exposure, logically as they are more bond like with more stable earnings, to term risk and thus have benefited greatly from long term secular trend in lower rates.
The data on the low volatility anomaly is robust prior to 1980.

You can take the return of any portfolio and correlate it to specific factors for any given time period. Look at a different time period and the correlations are completely different. For any given time period, Larry always has a reason as to why the performance of low volatility stocks should be dismissed. For one period he'll say, "bonds did great and so did low vol, hence low vol is useless." Then for another period he'll say, "value did well, and so did low vol., hence low vol. is useless."

I will say that over the past several years I wished I had owned less of the stocks Larry touts (value stocks) and more of the stocks he hates (low vol), but such is the risk of a multi-factor portfolio.

If what you want is low volatility, one can try to time moves into the whatever segment of the market happens to be behaving similarly to low. vol. at the moment, or one can just buy low volatility stocks. I'd suggest the later is the better way to achieve that goal.

Low volatility stocks should not be expected to beat the market over the long haul. I would expect them to continue to provide a higher Sharpe ratio than than the overall market. Whether this is useful in a portfolio if subject to debate and is of course depends on ones particular AA (as I discussed above).
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Re: The Value of Low Volatility

Post by ANC »

Once you have been through a downturn with an outperforming low volatility fund, it is easy to think you have the secret to investing. I thought so, until I joined this forum and read posts like those of Robert T and Larry S in this thread.

We used to have several funds that invest in this area, but not so much now.
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Re: The Value of Low Volatility

Post by larryswedroe »

stlutz
First, low volatility never did great, it is that high volatility has done awful. In fact the middle deciles/quintiles have higher returns (though not higher risk adjusted returns) than did the lowest vol quintile

Second, there are logical reasons for the low vol anomaly and limits to arb allow it to persist. But IMO the best strategy is simply to avoid the high vol without needing to buy the low volatility.

Third, yes low vol did well before 1980 but they were also VALUE stocks, with high value exposure then, now they are negatively loading on that factor. Valuations matter and now they are at extreme levels.

Personally I think today low vol predicts just one thing, low vol.

Larry
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Re: The Value of Low Volatility

Post by freyj6 »

Larry what are your thoughts on consumer staples funds like XLP and VDC as a substitute for low-vol?

Valuations seem to be through the roof right now, but assuming an environment where valuations are similar to the broad market, do you think they might have a place? Or are there fundamental reasons why performance should be poor going forward (other than sky-high valuations)?

I ask because they seem to have much lower volatility than many of the low-vol funds and, it seems, could be used productively for rebalancing in a portfolio with heavy momentum, EM and small-value tilts.

Thanks!
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Re: The Value of Low Volatility

Post by Phil DeMuth »

This is a nifty discussion and I would like to throw a few points into the fire.

1) Low volatility stocks tend to be low beta stocks as well: the same names crop up on both lists. And low beta stocks do a wonderful job of diversifying a portfolio. They tend to have lower correlations to the index and lower correlations to each other. When you increase diversification at the same level of expected return, you lower risk (and achieve higher Sharpe ratios). When you lower risk, you increase the geometric return of the portfolio. That is a nontrivial benefit.

2) You don't get rich in 1996-2000 and then lose your shirt in 2000-2003. Low vol is the little engine that could, chugging along in a variety of environments. Your higher long-term geometric return is a benefit for accepting the tracking error to the benchmark when the rest of the market is taking off (a psychological cost that should not be underestimated, such as when your spouse points out the new Lexus in your idiot day-trading neighbor's driveway).

3) When last I looked at this (2007), I did *not* find that I could replicate the effects of low beta stocks by using a stock index plus cash or plus short-term bonds. I got better risk-adjusted returns by using more low-volatility stocks with less cash/short-term bonds than using less stock index fund and more risk-free assets: it didn't look like an even trade. What is more, given the post-2008 flight to safety, my impression is that this approach has worked even better since.
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Re: The Value of Low Volatility

Post by patrick013 »

I think low volatility funds can be described as defensive
funds in a portfolio. But could be disappointing over the
long term. The main sector for a defensive AA would be
utilities. The other sectors may have low volatility stocks
but utilities has steadier returns.
age in bonds, buy-and-hold, 10 year business cycle
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Re: The Value of Low Volatility

Post by Erwin »

Phil DeMuth wrote:This is a nifty discussion and I would like to throw a few points into the fire.

1) Low volatility stocks tend to be low beta stocks as well: the same names crop up on both lists. And low beta stocks do a wonderful job of diversifying a portfolio. They tend to have lower correlations to the index and lower correlations to each other. When you increase diversification at the same level of expected return, you lower risk (and achieve higher Sharpe ratios). When you lower risk, you increase the geometric return of the portfolio. That is a nontrivial benefit.

2) You don't get rich in 1996-2000 and then lose your shirt in 2000-2003. Low vol is the little engine that could, chugging along in a variety of environments. Your higher long-term geometric return is a benefit for accepting the tracking error to the benchmark when the rest of the market is taking off (a psychological cost that should not be underestimated, such as when your spouse points out the new Lexus in your idiot day-trading neighbor's driveway).

3) When last I looked at this (2007), I did *not* find that I could replicate the effects of low beta stocks by using a stock index plus cash or plus short-term bonds. I got better risk-adjusted returns by using more low-volatility stocks with less cash/short-term bonds than using less stock index fund and more risk-free assets: it didn't look like an even trade. What is more, given the post-2008 flight to safety, my impression is that this approach has worked even better since.
Good comments; however, a casual look at the iShares LV funds show that they are overvalued relative to the regular funds. For example, based on M*, the P/E of the LV US ETF (USMV) is 21.80 versus 18.5 for the Russell 1000 ETF (IWD). Is this not a concern?
Erwin
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Re: The Value of Low Volatility

Post by stlutz »

ood comments; however, a casual look at the iShares LV funds show that they are overvalued relative to the regular funds. For example, based on M*, the P/E of the LV US ETF (USMV) is 21.80 versus 18.5 for the Russell 1000 ETF (IWD). Is this not a concern?
I think for the entire [almost] 5 year existence of USMV, it has traded at a 10-15% premium to the overall market in terms of PE. It's stylebox is Large Cap Core and has been again for its entire existence.

Sometime value stocks have lower volatilty; sometimes growth stocks do. At least in this decade, growth stocks have had lower volatility, hence there are more of them in USMV. Things may well change in the future and USMV will own more value stocks.
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Re: The Value of Low Volatility

Post by larryswedroe »

freyj6, sectors such as you note are not "factors" that explain returns. So I would not use them. Having said that there are two things that matter IMO. The first is what exposure the investment has to the factors that explain almost all the variation in returns of diversified portfolios, and what are the valuations. Almost nothing else matters. And since we don't know which factors will outperform when I'm big proponent of hyper diversification across factors with premiums, not only across stocks but other asset classes. Diversification is the only free lunch so you might as well eat as much of it as you can.

STLutz
We know that valuations matter and they matter a great deal. But with that said they don't really matter with factors such as momentum. Though of course I'd rather buy momentum stocks that are value stocks as well than growth stocks, so you get both premiums.

And now USMV is trading at higher than a 10-15% premium. The btm is about 1/3 higher and the p/e is about 18% higher. But using that time frame is IMO foolish, it happens to be the life of the fund, so longest you have. But we have data going back to 1927 and they used to look like value stocks with high loading on value. It was the bear market of 2008 that led to the demand so that changed the nature of the funds so that by start of fund it was already changed from value to growthy. And so have had good returns since then partly due to valuations going much higher. This is the argument that Arnott is making about premiums that get crowded. Personally I think he overstates the case, even greatly, but his general point is correct.

Unless you believe that valuations are irrelevant you should now expect much lower returns to low volatility. Now the only issue is this: Are valuations only a second or third order metric when it comes to low volatility. Clearly it matters on most of the other factors such as beta, size, value, quality, profitability. But it doesn't matter much with momentum. Personally I'm not willing to believe that it doesn't matter here. Cannot think of reason why it shouldn't. If you can explain why it shouldn't I'd love to hear the arguments because I do believe there is a good logical reason for the low volatility phenomenon, though it is mostly a high vol, not a low vol phenonomenon. Just ignore the high vol and you get almost all the benefits.

FWIW, I have discussed this issue in great detail with some of the leading thinkers on the issue, including big proponents of low vol.

Hope that helps
larry
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Re: The Value of Low Volatility

Post by Phil DeMuth »

>> A casual look at the iShares LV funds show that they are overvalued relative to the regular funds. For example, based on M*, the P/E of the LV US ETF (USMV) is 21.80 versus 18.5 for the Russell 1000 ETF (IWD). Is this not a concern? <<

Yes! Higher price today = lower returns tomorrow.

According to data copped from AQR, the richening of the low beta factor has only accounted for 0.3% of the annual returns, 1968-2016. The rest (4%) is due to the secular work of the factor itself (note that the factor is Low minus High beta, and different from a long-only strategy such as USMV). So the high P/E may not be the end of the world.

I consider the recent run up to be a distraction from their main purpose, which is to lower portfolio volatility more efficiently than cash/bonds do. Over the next twenty years I expect them to continue to perform this function. I haven't sold them, which is a revealed preference that I still must like them.
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Re: The Value of Low Volatility

Post by larryswedroe »

Phil
Yes this is an issue of whether valuations are first or say third order issue when it comes to low vol. Obviously not a first order issue with MOM. But here I'm not sure and don't like the bet when valuations are so high. Especially since you don't get higher returns anyway with low vol, just low vol. To me the more efficient way to get low portfolio vol is to tilt more to the other factors and use more safe bonds, the barbell type strategy.

Best wishes
Larry
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Re: The Value of Low Volatility

Post by Phil DeMuth »

Larry -

I was recently at a tax conference having lunch with a bunch of accountants, all BAM alliance members. These guys speak of you in reverential tones. They told me that whenever the chips are down, all their clients want to know is, "What does Larry say?" and that settles the matter.

It reminded me of Charlie Munger's comment that to be rightly trusted by people is a great honor.

Best,

Phil
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Re: The Value of Low Volatility

Post by Trader/Investor »

I have been writing about the value of low volatility since the 90s. But not as an investing tool but a trading tool. It was low volatility that got me hooked on junk bond funds in 1991. That was when PRHYX (and other junk bond funds) went three straight months without one down day whatsoever. Over the years I developed my own trading strategy using junk bond funds (corp and munis) that exploits this persistency of trend combined with low volatility. The power of low volatility and trend persistency is you are able to have your entire nest egg at work = consistent compounding of capital over time.
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Re: The Value of Low Volatility

Post by larryswedroe »

Phil
thanks for sharing, nice to know when you are respected, especially by other professionals.

Best wishes
Larry
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Re: The Value of Low Volatility

Post by Dancer »

FWIW, the Vanguard Global Minimum Volatility fund, relative to other Vanguard funds, is a Mid-Cap fund ($8.1B avg Market cap) with valuations in line with their Mid-Cap Value fund (P/E, although not P/B.) And a bit more balanced across sectors (other than very low in Energy, high in Consumer Defensive.)

Both have higher valuations (PE) than SP 500 or VG Total World, and I assume VGs value funds aren't the most value-ie, but above discussion got me curious...

Have owned VG Global MinVol since early 2015 -- so far doing what I expected.

But who knows what the future holds (why also own SP 500, SCV, Intl, Bonds, ...)
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Re: The Value of Low Volatility

Post by larryswedroe »

Dancer
FWIW, IMO since we don't know which factors will deliver premiums in the future the most prudent strategy is hyperdiversification if you will. Diversify across many which have shown persistence, pervasiveness, robustness, implementable (survive costs) and intuitive. Low vol has met all those criteria. My one concern is high valuations. And I don't know if that is a first or third order issue here. With many others like value and size and beta it's clearly first order, With MOM it may not matter at all. And of course low vol works across asset classes, working in bonds as well (for same reasons, people overpay for optionality, those lottery tickets). So having some exposure to low vol is probably fine. But I would not count on market like returns, though think can count on low vol
My own view is that I'm diversified across many factors already so adding low vol may not matter much, and I dampen portfolio volatility with the barbell strategy of having low equity allocation and high tilt to other factors. Remember adding another factor gets you decreasing benefits ---for example how can low vol add much if beta, size, value, momentum already get you about 95% of the explanatory power of portfolio returns?

Hope that helps
larry
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