Our Insights

About personal finance, investments and markets.
May 11, 2016

The problem with low volatility investing

In the aftermath of the financial crisis and a sluggish economic recovery it is probably no surprise that investors are interested in strategies that promise equity market-like returns with lower risk. Low-volatility funds have seen the biggest inflow of any equity strategy. It is clear that the concept sells – but should you buy? Today, we would stay away because the low volatility strategy combines two classic investing pitfalls: (1) chasing returns and (2) buying at a high valuation.

Nothing sells better than past performance

If you have been long enough in this business, you will know that the principal determinant of retail fund flows is recent performance. When it comes to low-volatility investing, the strategy has clearly delivered – and then some. Comparing the MSCI World Minimum Volatility Index to the plain vanilla MSCI World, we can see that it has outperformed over a 1, 3, 5 and 10 year period. Truly impressive and anyone who bought into this strategy will feel vindicated. It is therefore no surprise that in the US and in Germany, minimum volatility products have seen the biggest inflow during 2015 and 2016 YTD.

MSCI

It’s all good then – or is it not?

The Factor Investor blog published several excellent posts on low volatility investing. Currently, the lowest-volatility decile of stocks has a P/E ratio that is 34% more expensive than its 52-year historical average. History has shown that buying expensive assets typically leads to below-average long-term returns.

PE

One can also look at the performance of the staples sector, which is probably the poster-child for low-volatility stocks. The S&P Staples Index has risen by more than 90% over the last 5 years. However, a large part of that performance was driven by multiple expansion with the P/E ratio rising from approx. 15x in 2011 to currently 22.6x. Trees don’t grow to the sky.

SP Staples Index

Research Affiliates, which manages more than $150bn, recently published a detailed long-term study breaking down the return drivers for some of smart beta factors such as low volatility. The key point was that the outperformance of low vol strategies over the last 10 years is mainly the result of rising valuation multiples. But this is likely neither sustainable nor repeatable!

RAFI

When you parse the marketing pitch for strategies such as low vol investing, you will typically find a reference to strong backtests. But this is highly misleading! A strong backtest at any point in time may be because the factor tested has become expensive – which is the case for low vol investing in our opinion.  Counter-intuitively, a strong backtest almost becomes a reason not to buy into a strategy!

Summary

Excessive crowding of any strategy should send up a flag of warning. The low volatility investment theme may continue to work for awhile. But it is unlikely to work forever – because nothing does. Especially not once an asset class trades significantly above average historical valuation.

If you are committed to a core holding as a cornerstone of a portfolio for a decade or more, sacrificing long-term performance to avoid daily or monthly swings is the wrong way to invest.