Why Valuations Don’t Matter for Low Volatility Investing
Low volatility ETFs have experienced a surge in interest in recent years. Given the financial market’s sometimes gut-churning ups and downs, it’s not surprising that many investors are seeking out funds designed to swing less in value than the market as a whole.
However, in the wake of this newfound popularity, some investors are asking if low volatility portfolio valuations have risen too far, too fast. Indeed, a few market watchers have even called for “overpriced” low volatility funds to come crashing back to earth.
Are they right? Can the low volatility investing party end? Or are there still opportunities for investors to profit from this important investment strategy?
In our research-based white paper, Cheap or Expensive — It Isn’t as Important as You May Think: Why Valuations Don’t Matter for Low Volatility Investing, Horizon examines the role that relative valuations play in predicting low volatility investments’ future returns and future volatility levels.
For our analysis, we created portfolios of the top 10% of stocks from the S&P 500 index, sorted by historical volatility and weighted by the inverse of the historical volatility, which yielded a concentrated low volatility portfolio that gave more weight to the least volatile securities. We then examined price-to-earnings ratios, price-to-book ratios and price-to-cash flow ratios, as well as relative volatility, for these portfolios over both rolling one-year and rolling five-year time periods. The evaluation period included multiple market cycles, including the tech bubble of the early 2000s and the mortgage crisis and recovery of 2007-2009.
Based on our analysis, we made these four key conclusions:
- The current relative valuations of low volatility portfolios do little to predict the portfolios’ future relative returns. There is some evidence that today’s valuations are related to subsequent returns over longer horizons, but it is tenuous at best. The evidence is even weaker over shorter periods.
- Different valuation metrics yield inconsistent conclusions when analyzing the impact of current valuations on the subsequent returns of low volatility portfolios. The various impacts of the portfolio’s current valuations on the portfolio’s future returns—the “valuation effect” —are entirely inconsistent depending on which valuation measurement (P/E, P/B, P/FCF) is used. This is true even over longer horizons.
- Low volatility portfolios’ current relative valuations cannot reliably predict subsequent relative volatility of the portfolios. There is no apparent relationship between relative valuations and subsequent relative volatility, regardless of the valuation measure used or the time horizon examined. This finding is particularly important because the primary mandate of low volatility strategies is to provide exposure to portfolios with lower aggregate volatility than the broad market.
- Valuation should not be used as an investment timing tool. Using the current relative valuations of low volatility portfolios as a method of “timing” one’s decision to buy and/or sell these portfolios is unlikely to generate outperformance.
Why it matters
Conclusion: Investors should not let the relative valuations of low volatility portfolios at any one moment in time be the deciding factor in their decision to invest (or not invest) in this increasingly popular strategy.