We are believers in low volatility, just not at any price.
Recently, low- or minimum-volatility ETFs have been all the rage. PowerShares S&P 500 Low Volatility SPLV and iShares MSCI USA Minimum Volatility USMV have combined to attract $9 billion in assets in less than two years since inception. SPLV selects the 100 least-volatile stocks from the S&P 500, and it is touted as a simple way to take advantage of the low-volatility anomaly. However, there is perhaps an even simpler way: mega-caps.
For those of you unfamiliar with the low-volatility anomaly, a short review is in order. In the 1970s, Fischer Black observed that low-beta stocks, which were less sensitive to the broad market's gyrations, performed nearly identically with high-beta stocks. This contradicted a fundamental prediction of the capital asset pricing model, or CAPM, which was that higher beta equals higher returns. A number of more recent studies have shined a light on the anomaly, including "Benchmarks as Limits to Arbitrage: Understanding the Low Volatility Anomaly," by Baker, Bradley, and Wurgler.
This study argues that some investors prefer higher-risk strategies with the biggest potential upside. How else can we explain the popularity of lotteries despite the fact that they are negative net present value investments? Further, institutions such as mutual funds are restricted in the use of leverage but have incentive to beat a benchmark, so they seek out high-risk beta stocks that give the highest potential returns. This results in high-beta stocks being bid up to the point where future returns are lower than expected.
A number of ETFs have come to market to exploit the phenomena. But the recent popularity of low-volatility strategies probably owes to the fact that investors have been exceptionally risk-averse since the financial crisis, and low-volatility strategies held up better during that period. In the four years since the market peaked in October 2007, the S&P 500 lost a cumulative 11% while the S&P 500 Low Volatility Index gained 14%.
In the Land of the Giants
Mega-cap stocks are blue-chip companies, international conglomerates, or firms with strong brands and wide economic moats. These companies are large for a reason. Their industry dominance and diversified revenue streams result in more predictable earnings, which makes their stock prices less volatile. Morningstar defines mega-caps as those in the top 40% of the cumulative market capitalization, which currently puts them at $56.8 billion or greater in market cap. At this cutoff, only about 55 companies would qualify as mega-cap.
There are a number of mega-cap-themed ETFs, including iShares S&P 100 Index OEF, Guggenheim Russell Top 50 Mega Cap XLG, SPDR Dow Jones Industrial Average DIA, and Vanguard Mega Cap MGC. OEF tracks the 100 stocks from the S&P 500 with liquid options markets. XLG tracks the 50 largest companies from the Russell 1000, giving it the highest average market cap at $163.3 billion. DIA tracks the well-known Dow Jones Industrial Average, a price-weighted index of blue-chip companies. MGC is the cheapest option, but the CRSP index it follows dips into large-cap territory, so it has less pure exposure to mega-caps.
Risk and Return
Historically, mega-cap stocks have been somewhat less volatile than the market overall. The S&P 500 has had a volatility of return of 15.4% since 2002, while the Russell Top 50 Index has been somewhat less volatile at 14.8%. While slightly less volatile, mega-cap stocks do not necessarily benefit from the low-volatility anomaly. The Russell Top 50 Index had an annualized return of 3.2% during that period, less than the 4.9% return of the S&P 500. However, the S&P 500 Low Volatility Index had a much lower volatility at only 10.5% and a much higher return at 8.6%. So it seems that a portfolio of stocks built on large size does indeed have lower volatility but does not have the same outperformance as a portfolio built by targeting low-volatility stocks explicitly.
We can examine risk and return going back even further than 2002 by using data from Kenneth French's website. He divides all of the stocks in the market into 10 buckets. We will designate decile 1, which contains the largest 160 or so stocks, as mega-cap; decile 10, which contains the smallest 1,422 out of 3,551 stocks, will be micro-cap. When plotting the risk on the y-axis and return on the x-axis, the deciles seem to form an upward sloping line, with the mega-caps having the lowest risk but also the lowest return.
Source: Kenneth French.
Taking less risk by investing in mega-caps was rewarded with less return, confirming the predictions of the CAPM. There is no anomalous return here. While mega-caps are slightly less volatile than the broad market, they do not give investors access to the low-volatility phenomenon.
PowerShares S&P 500 Low Volatility has outsized bets on certain sectors. Mega-caps are more sector neutral. Compared with mega-caps, PowerShares S&P 500 Low Volatility is overweight utilities, consumer staples, and real estate, investing nearly 64% of its assets in these three sectors compared with just 14% for Guggenheim Russell Top 50 Mega Cap. That is an overweighting of 50 percentage points. At the same time, PowerShares S&P 500 Low Volatility is underweight financials, energy, technology, and health care, which make up 18% of assets compared with 64% for Guggenheim Russell Top 50.
Low Risk, but Not at Any Price
Clearly, portfolios of less-volatile stocks have a performance edge over the long run, but is now a good time to invest in this strategy? Low-risk stocks and those with a high dividend have had excellent recent returns, but they are beginning to look expensive. During the past year, PowerShares S&P 500 Low Volatility has returned 22% compared with 13% for Guggenheim Russell Top 50. That sort of performance differential is unsustainable.
On a valuation basis, stocks in PowerShares S&P 500 Low Volatility currently trade at a price/fair value of 1.10, which is overvalued compared with the 0.96 price/fair value for Guggenheim Russell Top 50. Price/fair value is our preferred valuation metric, and it is based on a bottom-up analysis of each portfolio constituent. Morningstar has more than 100 equity and credit analysts, and they build detailed cash flow projections on each company they cover. These projections form the basis of a fair value estimate that can be aggregate at the portfolio level.
Additionally, stocks in PowerShares S&P 500 Low Volatility trade at a much more expensive price/forward earnings of 17.4 times compared with 13.8 times for Guggenheim Russell Top 50. Despite the cheaper valuations, mega-caps actually have grown more quickly than low-volatility stocks. Stocks in Guggenheim Russell Top 50 grew earnings by 11% compared with 7% for PowerShares S&P 500 Low Volatility. Usually, investors pay more for growth. The fact that PowerShares S&P 500 Low Volatility has had lower earnings growth but still trades at a higher price/earnings indicates that investors are currently paying a premium for the perceived safety of these stocks.
We like the benefits of the low-volatility strategy, but based on valuation, a better approach at the current time is to invest in mega-cap stocks.