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Due to uncertainty in financial markets, low-volatility stocks are in high demand. According to Pim van Vliet, portfolio manager of Conservative Equities, a generic low-volatility strategy is getting more expensive. An enhanced approach is necessary to prevent buying too expensive stocks.
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Yes, we do find that a generic low-volatility strategy is getting more expensive compared to the market index, based on valuation metrics such as price-earnings (P/E) ratio. But our Conservative Equity portfolios tend to have better scores on these metrics compared to low-volatility stocks in general.
The higher valuation of generic low-volatility stocks does not necessarily concern me. There is a good reason for the current popularity of low-volatility investing; investors have become more cautious after a series of crisis and crashes such as the Dotcom Crash in 2000, the Global Financial Crisis in 2008 and more recently, the euro-crisis. They want to avoid risk and prefer the safety of low-volatility stocks, and are willing to pay more for these.
The current market circumstances are similar to the 1940’s and 1950’s. With the memory of the Great Depression fresh in their minds, investors preferred low-volatility stocks.
Another reason why the higher valuation of low-volatility stocks compared to the market index does not overly concern me is that, in general, investors have been too optimistic about the prospects of high risk-stocks. A higher valuation of low-risk stocks should be the norm.
The valuation of our global portfolio based on P/E is 15.5, lower than the MSCI World, which has a P/E of 17.3, and lower than the MSCI World Min Vol, which has a P/E of 18.8 (end of June 2014). The dividend yield is more than 1% higher than the market, also higher than generic low-volatility stocks.
In general, investors have been too optimistic about the prospects of high risk-stocks.
For emerging markets, differences are more pronounced, the P/E for MSCI Emerging Markets is 12.0 and for MSCI Emerging Markets Min Vol 15.8, with our portfolio in between at 13.8. Our dividend yield is higher compared to both indices.
The reason that the valuation of our portfolios is lower is because our stock selection model does not just look at low-volatility, but also takes into account valuation. We enhance a generic low-volatility strategy by using several valuation factors, but also sentiment factors. Since the start of our Conservative Equity strategies in 2006, we have used this enhanced approach.
In these circumstances where generic low-volatility is more expensive, it is important to make a good screening. Not all low-volatility stocks are equal. In periods like this it makes a big difference in returns. Our enhanced strategy works especially well when low-volatility is expensive. This is based on research of a database going back 83 years.
We choose a sample period that is as long as possible and split this sample into two groups: one where low-volatility stocks have a relatively low P/B and one where they have a relatively high P/B. Within these groups, we looked at a market index, a generic low-volatility strategy and the enhanced low-volatility strategy. We compared how well the three groups performed. Our research shows that the return difference between the two low-volatility approaches is up to 6% per year on average in favor of the enhanced low-volatility strategy. This is higher than when low-volatility is not expensive.
Beware of what you buy; especially now low-volatility investing is becoming more popular.
Beware of what you buy; especially now low-volatility investing is becoming more popular. Investors should pay attention to valuation when buying low-volatility stocks: not all low-volatility portfolios are equal. The lower valuation of our portfolios compared to generic low-volatility stocks, combined with the strength of our stock selection model, distinguishes us from the competition.
Another thing that investors should keep in mind is that when markets rise strongly, low-volatility stocks may lag the broader market, although low-volatility investing leads to better risk adjusted returns in the long term.
Please note: this article was initially published on June 5th 2013. On July 25th 2014, we have updated the article's figures.
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