Low Volatility Factor: Interest Rate Sensitivity & Sector-Neutrality

Are Low Vol Stocks Bond Proxies?

April 2018. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • The interest rate-sensitivity of the Low Volatility factor has increased in recent years
  • Mainly due to the sectoral biases from the long portfolio
  • Sector-neutrality reduces the interest rate-sensitivity, albeit at the cost of performance

INTRODUCTION

Low Volatility strategies have become popular over recent years and become a staple in factor portfolios. From a classic financial theory perspective the strategy is somewhat problematic as it undermines the expectation that higher risks are rewarded by higher returns. However, academics and investors have provided a theoretical foundation by explaining the positive excess returns with investor lottery preferences and restrictions on leverage. One frequent criticism is that low volatility stocks are bond proxies as these stocks tend to be stable businesses with significant amounts of leverage. In this short research note we will analyse the interest rate sensitivity of the Low Volatility factor in the US and evaluate a sector-neutral approach (read Factors & Interest Rates).

METHODOLOGY

We focus on the Low Volatility factor, which selects stocks based on their volatility over the last 12 months. The long portfolio includes stocks that exhibit low volatility while the short portfolio is comprised of highly volatile stocks. The factor is created by constructing a long-short beta-neutral portfolio of the top and bottom 10% of stocks of the US stock market. Only stocks with a market capitalisation of larger than $1 billion are included. Portfolios are rebalanced monthly and each transaction incurs costs of 10 basis points (read Low Volatility: High Factor Valuation).

INTEREST RATE SENSITIVITY OF THE LOW VOLATILITY FACTOR

The chart below highlights the factor betas of the long and short portfolios of the Low Volatility factor to an interest rate index, specifically the iShares 7-10 Year Treasury Bond ETF, which were derived from a regression analysis with a one-year lookback. We can observe that the factor betas of the long portfolio have been zero on