Low Volatility Stocks Trading at a Premium

Hello and welcome to my Substack! For those who may not know me, I've spent nearly three decades as a leading voice in investment research and strategy, most recently as the head of investment research and strategies at Buckingham Strategic Wealth (until my retirement in June 2024). My work has been featured in numerous publications, including Wealth Management, Financial Advisor, Morningstar, and Alpha Architect, as well as in peer-reviewed journals. I've also authored or co-authored 18 books on investing, behavioral finance, and wealth management.

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Low Volatility Stocks Trading at a Premium

In 1972, Fischer Black documented the superior performance of low-volatility stocks. The low-volatility anomaly (it’s an anomaly because lower volatility stocks are less risky and should, therefore, provide lower, not higher returns) has persisted in both equity and bond markets around the world.

The publication of the empirical findings that low volatility stocks provided superior led to the introduction of funds to exploit the anomaly. However, follow on research found that the performance of low volatility stocks was fully explained by their exposure to other common factors used in asset pricing models (equity factors of size, value, quality, profitability, investment and the bond term factor). In other words, low volatility was not truly a unique factor. Importantly, the research also demonstrated that the low-volatility anomaly was only present when low volatility stocks were cheap (they were also value stocks).

We can see the valuations of low volatility stocks relative to the S&P 500 by comparing the current (as of 2/24/25) P/E ratio of the Invesco S&P 500® Low Volatility ETF SPLV (a popular fund for accessing the low volatility factor as evidenced by the $7.5B it has under management) at 23.6 (trailing 12 months) relative to that of the Vanguard S&P 500 Value ETF (VOOV) at 22.4. And, by comparison it is trading at dramatically higher (more than one-third higher) valuations than either that of the Avantis US Large Cap Value ETF (AVLV) at 16.5 or the Dimensional US Large Cap Value ETF (DFLV) at 16.5.

History Lesson

Over the period 2016-2022, when low volatility stocks were trading at a premium to the S&P 500 Index, SPLV returned 9.8% per annum and underperformed Vanguard’s S&P 500 Admiral Shares Fund VFIAX which returned 11.4% per annum, an underperformance of 1.6% per annum. With that said, SPLV did experience lower volatility (standard deviation of 13.3% vs. 16.3%)— demonstrating that past low volatility does predict future low volatility. SPLV did also have a slightly lower worst-case drawdown of -21.4% versus -23.9%. In terms of risk-adjusted performance, the two funds produced virtually identical Sharpe ratios.

Investor Takeaway

The low-beta anomaly was documented more than 50 years ago. It has been persistent and pervasive around the globe and across asset classes. However, newer research demonstrates not only that returns to the anomaly are well explained by exposure to what are now considered other common factors, but also that the premium is dependent on whether low volatility is in the value or growth regime.

Unfortunately for investors in low-volatility strategies, the popularity of the strategy has caused valuations to leave the regime where they had historically generated alphas.

The bottom line is that returns to the low volatility anomaly have only justified investing when low-volatility stocks were in the value regime, after periods of strong market performance, and when they excluded high-volatility stocks that have low short interest (providing clues as to how to improve its performance). This may be why live funds have been generating large negative alphas once we account for common factor exposures.

Lodewijk van der Linden, Amar Soebhag, and Pim van Vliet, authors of the October 2024 paper “Leveraging the Low-Volatility Effect,” showed that low volatility strategies can be enhanced by also screening for the value and momentum factors. Unfortunately for US investors, while Robeco does offer these funds in the form of UCITS (Undertakings for Collective Investment in Transferable Securities) in Europe, Latin/South America, Asia, and Canada, in the US they only offer them in segregated accounts. I’m not aware of any US mutual funds or ETFs that currently incorporate this improvement.

Stay tuned.

In the meantime, investors seeking higher returns might want to reconsider investing in low volatility strategies given the currently relatively high valuation of low volatility stocks. With that said, the historical evidence does demonstrate that past low volatility does predict future low volatility. Thus, should we enter a bear market, while low volatility stocks won’t protect you from a drawdown, their drawdown is likely to be somewhat lower than the drawdown of the S&P 500.

Larry Swedroe is the author or co-author of 18 books on investing, including his latest Enrich Your Future.