EXECUTIVE SUMMARY
• Low volatility strategies, as the name suggests, typically perform well when markets decline. Challenging traditional capital asset pricing theory, they have, anomalously, outperformed their benchmarks over time despite exhibiting lower risk.
• Due to their popularity in recent years, some critics have claimed that low volatility stocks are overbought and overvalued.
• We attempt to quantify the current valuation of low volatility. Moreover, we ask if it is possible to identify valuation environments during which low volatility strategies offer more bang for the buck.
• Relative valuation for the S&P 500® Low Volatility Index has gradually become more expensive since 2000; at the end of 2019, the low volatility index was modestly cheaper than its parent S&P 500. However, as a leading indicator of the relative performance of low volatility strategies, value has never been particularly valuable.
THE RISE OF LOW VOLATILITY
What is commonly referred to as the low volatility anomaly is not a recent discovery; it has been well documented in academic research for over four decades.1 Popularized in the turmoil following the 2008 financial crisis, low volatility strategies, as the name suggests, have served well in times of market distress. The anomalous aspect is that despite their lower risk, low volatility strategies have outperformed their benchmarks over time, challenging classic capital asset pricing theory that risk and reward go hand in hand. The long-term outperformance of low-risk portfolios is perhaps “the greatest anomaly in finance.”2
The S&P 500 Low Volatility Index3 is one example of such a strategy. From January 1991 to December 2019, this index delivered an average annual return of 11.28%, compared with 10.44% for the S&P 500, with less volatility (standard deviations of 11% and 14%, respectively). This same risk/return profile is consistent with history extending to the 1970s.4
In recent years, low volatility strategies have gained fortune along with fame, gathering about $130 billion in assets in more than 200 funds globally.5 Along with the generous inflows, concerns have risen around the valuation of the portfolios tracking low volatility strategies.6
