Timing Low Volatility with Factor Valuations

How Important Are Valuations for Expected Returns?

February 2020. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Factors can be valued like stocks or markets
  • The Low Volatility factor in the US had the best subsequent returns when cheapest and worst when most expensive
  • However, the perspective is less clear when analyzing European and Japanese stock markets

INTRODUCTION

Funds flows are frequently analyzed by investors to gauge the demand for investment strategies, but it represents a challenging exercise. Key issues are data availability as few market participants disclose their holdings and reporting frequency as limited data is published in real-time.

The resulting headlines in media, therefore, are often confusing, although they naturally also reflect that fund flows can change quickly as investor sentiment shifts. For example, glancing at a few headlines regarding the Low Volatility factor from the last few months would likely leave investors questioning whether this strategy is popular or not.

  • Investors quickly tired of Low Volatility ETFs (Investopedia, 25th June 2019)
  • Money is pouring into Low-Volatility Funds (WSJ, 4th August 2019)
  • Min / Low Volatility in demand on macro concerns (ETF Stream, 25th August 2019)
  • November rally weighs on Low-Volatility funds (WSJ, 11th November 2019)

The interest in fund flow data is either based on evaluating the potential for returns or risks of an asset class or strategy. The more demand from investors, the higher the returns should be as new money will drive prices higher. However, if a strategy becomes too popular and there are few buyers left, then it might be considered crowded and become prone to drawdowns when the popularity fades.

A simpler and more established method of evaluating the risk-return profile of a strategy is valuation, where high-quality and real-time data is available. Although valuation is common when analyzing stocks, it is less frequently applied when evaluating the attractiveness of factors.

In this short research note, we will evaluate the relationship between the fundamental valuation and subsequent returns of the Low Volatility factor (read Low Volatility: High F