Is low vol flying too high?
Author: Abhishek Ashok
August 6, 2019
Low volatility has been one of the best-performing factors during the rally in equity markets this year, but that may not last given how significant low vol’s outperformance has been in relation to value, the most out-of-favour factor over the past six months.
While it may not be intuitive to pit the returns of low volatility and value against each other in the same way as investors regularly do for growth versus value, extreme divergences in the valuation of these two factors often signal important inflection points in the future performance of each.
At the height of the Great Financial Crisis in the fall of 2008, for example, the valuation spread between the lowest volatility stocks and the cheapest stocks (based on forward earnings) in the S&P 500 index was more than six standard deviations from its four-year average as investors fled to “risk-off” securities and shunned value stocks in the wake of enormous market uncertainty.
However, less than six months later in the spring of 2009, this same spread was back to less than one standard deviation away from its norm as value rallied relative to low vol.
Valuation spread between value and low volatility stocks
A similar outcome was also true of the S&P/TSX Composite Index in Canada during that time frame and, on indices both sides of the border, there are several other instances in the past 20 years when larger deviations in the valuation spread between low vol and value have resulted in mean reversion shortly after.
Today, the valuation spread between these two factors has reached between two and four standard deviations away from the norm in the U.S. and Canada, respectively. Those are levels not seen in over a decade, suggesting value and/or higher volatility segments of the market may be due for an uptick in performance.
At the very least, investors should be cautious about their exposure to low volatility stocks going forward and maintain a multi-factor approach to prevent from getting caught too much offside.
Abhishek Ashok is an analyst at Highstreet Asset Management Inc. and a member of the AGFiQ quantitative investment team.
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