Low volatility does not always mean low risk

Dec 6th, 2018 | By | Category: Equities

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By Jay Beidler, co-Founder of Distillate Capital.

Jay Beidler, co-Founder of Distillate Capital.

Jay Beidler, co-Founder of Distillate Capital.

Low volatility, or low beta, as an investment concept has garnered a lot of attention and investment dollars in recent years. One reason for this is the high level of anxiety about geopolitical turmoil, political discord, negative interest rates, elevated levels of global debt, trade disputes, and a host of other issues.  The other reason is increased awareness of the “low beta anomaly,” in which lower beta stocks actually produce higher long-term returns.

The low beta anomaly contradicts the expected relationship between risk and return and highlights the tremendous benefit of limiting large price declines, or drawdowns. The impact of such declines is enormous when considering compounded returns but much less meaningful when looking at average returns. For example, a 50% decline followed by a 50% increase produces an average return of 0%, but a compounded total return of negative 25%.

This same dynamic is evident when looking at portfolios of stocks. Using the Ken French data series beginning in 1964 and sorting five groups of stocks by beta and rebalancing each year, there is a positive relationship between average returns and the volatility of those returns: the highest beta group produces both the highest and most volatile returns (see figure 1).

Figure 1: Average Return vs. Volatility by Beta

But this seemingly tight relationship between risk and return breaks down when returns are examined on a compounded basis as an investor would actually experience them (see figure 2). In this case, the highest beta group actually produces the lowest return while the second lowest group by beta does the best.

The low beta anomaly thus highlights the incredible long-term benefit of limiting drawdowns.

However, using beta as a forward-looking measure of risk to limit those drawdowns is problematic.

Figure 2: Cumulative Return by Beta, 1964 – 2017

Warren Buffett famously criticized the use of price volatility to measure risk in his 2014 annual letter when he wrote “…volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray.”

These are powerful words that run counter to the way many investors, including many professional investors, think about risk.

Nobel Prize-winning economist Robert Shiller also famously challenged the reliance on stock price volatility and the underlying presumption that price swings are perfectly rational. In theory, price volatility is used as a proxy for risk because short-term price moves fully capture all of the fundamental and market risks of an investment. It would follow then that stock price movements should be more stable than the cash flows they are supposed to discount since investors would look through temporary near-term disruptions in setting prices that reflect much longer-term expectations.

But in reality, the exact opposite is true, and prices are far more volatile than the underlying fundamentals. Shiller argued that this invalidates the assumption that prices are perfectly rational and perfectly measure risk.

So, if price volatility is a flawed measure of risk, it makes little sense to employ it on a forward-looking basis in an effort to reduce risk.

There are other issues as well.

One issue is that volatility can change quickly. Volatility itself is volatile. Something that was low beta may become high beta.

Currently, around 60% of the S&P 500 Low Volatility Index consists of stocks in the financials, utilities, and real estate sectors. Those same sectors represent only about 20% of the overall S&P 500 Index. But they also enjoy a certain commonality, all being highly sensitive to interest rates. It is worth considering whether their prior price volatilities may be more related to the recent interest rate environment rather than the underlying riskiness of their businesses.

It is also worth noting that stocks in these sectors tend to be substantially indebted. While debt is not inherently bad, its existence can amplify negative changes in valuations or underlying fundamentals. Will the low betas of the Low Volatility Index act as expected should interest rates change? We don’t know the answer, but the set-up to disappointment seems clear.

Another issue with stock price volatility is the price paid to attain less of it. The price paid for any asset is a critical variable in its ultimate return. Given the flight into low-beta strategies and the resulting increase in valuations for low-beta stocks, we think this is particularly relevant at present.

Low beta stocks have historically tended to be valued less expensively than the market. At present, however, low beta stocks are trading at a substantial premium on a wide variety of metrics, including EV/EBITDA (see figure 3). Buying any asset at a historical price premium strikes us as risky, no matter its other characteristics.

Figure 3: EV/EBITDA by Beta Quintile

Another Way to Measure Risk

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We believe there is a good alternative to assess risk that does not rely on stock price volatility and historical betas. Taking the route implied in Buffett’s 2014 letter, we instead look directly at company fundamentals to consider risk.

In our view, if the return on any investment is a function of its price in relation to the expected future cash flows it will generate, its riskiness must then relate to how likely those cash flows are to actually materialize and what will happen to the investment’s value if they do not.  We look at historical and expected fundamental stability to make that assessment.

Second, we incorporate valuation, or the price paid related to underlying worth into an evaluation of risk.

Lastly, we consider a company’s level of financial indebtedness. By controlling for stability (including looking at future estimates), valuation and leverage, we believe our measure is a more comprehensive and rigorous assessment of risk. Our methodology seeks to capitalize on moderating drawdowns in the same manner that the low beta anomaly did in the past, but without the valuation and fundamental risks that may challenge the performance of low beta stocks going forward.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)

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