FA Center: Are low-volatility stocks in a bubble?

FA Center: Are low-volatility stocks in a bubble?

CHAPEL HILL, N.C. (MarketWatch) — Some skeptics recently have argued that low-volatility stocks are forming a bubble that’s about to pop — and financial advisers therefore need to stop recommending them to their clients.

And since a lot is riding on this disagreement, it’s important to get to the bottom of it.

Low-volatility stocks are those that have exhibited low levels of historical price volatility. Though there is no one way in which analysts define volatility, the definition used by the late Robert Haugen — the finance professor who devoted much of his three-decade academic career to documenting the impressive performance of such stocks — is the standard deviation of monthly returns over the trailing two years.

Such stocks exhibit two characteristics that make them valuable to investors. The first: They tend to continue being low volatility and less risky than the overall market. In fact, one of the strongest patterns statisticians have documented in the stock market is the high correlation between a ranking of stocks based on their volatility in one period and a ranking based on their volatility in a subsequent period. This means that investors can reliably expect that a portfolio of stocks with low past volatility will continue to exhibit low volatility.

The second notable characteristic of low-volatility stocks is even more extraordinary: In the past they on average performed every bit as well as the market as a whole, if not better, and significantly better than the highest-volatility stocks. Professor Haugen was met with considerable skepticism when he first reported this result, since it flew directly in the face of what Finance 101 taught us about the relationship between risk and return. But this pattern was the consistent finding of a number of subsequent studies, both of U.S. stocks but also of stocks around the world.

Taking these two characteristics together, it meant that you could equal the market, if not beat it, while incurring substantially below-market risk. That’s a winning combination.

No wonder that financial planners have been urging low-volatility stocks to their risk-averse clients. Imagine such an investor who has previously concluded he should allocate only 50% of his portfolio to the broad stock market. For ease of illustration, assume that this client has allocated the other 50% of his portfolio to a money-market fund.

To appreciate what low-volatility stocks can do for this investor, consider the iShares Edge MSCI Minimum Volatility USA ETF USMV, -0.19%  , which is the largest of the several ETFs that invest in such stocks in the U.S. Its beta is 0.74, according to MSCI, which means that it historically has fallen 26% less than the S&P 500 during bear markets. Yet since the index’s inception in 1988, it has produced a 10% annualized return, versus 9.74% for the S&P 500.

Assuming the future is like the past, that client could instead invest 68% of his portfolio in the USMV and incur no additional risk. But his return would be dramatically better, since 18% of his portfolio that was otherwise earning a money market rate would now be earning an expected rate of 10.0% annualized.

But will the future continue to be like the past? That is the $64,000 question, since no strategy works forever in the wake of ever-increasing popularity.

One adviser who believes we’ve reached that point is Richard Moroney, editor of Dow Theory Forecasts. Earlier this month, he wrote to clients that low-volatility stocks are in a bubble, since their average P/E ratios currently are much higher than in the past.

For an additional perspective, I checked in with Nardin Baker, who co-authored with Professor Haugen many of the seminal research studies into the performance of low-volatility stocks. Baker currently is Chief Strategist at South Street Investment Advisors in Boston; he previously was a global equity manager at Guggenheim Partners.

Mr. Baker acknowledged in an interview that low-volatility stocks today are trading at higher valuations than they often have in the past. But, Mr. Baker quickly added, that doesn’t mean the low-volatility approach isn’t still compelling.

That’s for two reasons. The first: Low volatility isn’t merely a proxy for low P/E. If that were the case, then it would be more alarming that low-volatility stocks are now trading for higher P/E ratios.

But the low-volatility approach is more than that. To be sure, there have been times in the past when the lowest-volatility stocks also sported some of the lowest P/Es. This was the case in the early aughts, for example, when value stocks dominated the low-volatility universe.

But in recent years the low-volatility universe has drawn fairly evenly from both the value- and growth-stock camps, and as a result such stocks’ average P/E has risen. But that’s no reason to conclude that the low-volatility approach has stopped working.

The second reason that Mr. Baker argues the low-volatility approach remains compelling: Such stocks would have to trade at much higher valuations before it would be rational to avoid them.

Imagine, for purposes of illustration, that low-volatility stocks in the future lag the S&P 500 by a percentage point per year. That would represent a change, of course, since historically such stocks have equaled or beaten the broad market. But notice that they would still handily beat the S&P 500 on a risk-adjusted basis: They will forfeit 10% of the market’s return while immunizing followers from 26% of the risk.

That means you still will be able to improve your long-term returns, without any additional risk, by increasing your allocation to low-volatility stocks.

How much more expensive would low-volatility stocks have to become before they would no longer hold out the potential of beating the broad market on a risk-adjusted basis? Mr. Baker estimates that their average P/E ratios would have to be 30% higher than the S&P 500’s before this would be the case. Since they currently are just 5% higher, Mr. Baker concludes that low-volatility stocks still have a lot to offer.

To be sure, none of this discussion should be taken to mean that P/E ratios don’t also matter. Between two low-volatility stocks between which you are otherwise indifferent, the one with the lower P/E would certainly seem the better alternative. By the same token, however, you shouldn’t automatically avoid a low-volatility stock with a higher P/E ratio just because of that higher ratio.

The easiest way to invest in low-volatility stocks is via ETFs such as the USMV. The second-largest such ETF that invests in U.S. equities is the PowerShares S&P 500 Low Volatility Portfolio ETF SPLV, -0.22%  .

If you want to invest only in the lowest-volatility stocks that also have the lowest P/E ratios, however, you will have to construct the portfolio yourself. Below is a sampling of 10 low-volatility stocks in the S&P 1500 from different sectors that also have P/E ratios below that of the market as a whole (as identified by FactSet):

For more information, including descriptions of the Hulbert Sentiment Indices, go to The Hulbert Financial Digest or email mark@hulbertratings.com.