Bubble trouble in low-vol land?

Demand could be driving prices too high.

June 5, 2013

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bubble blowingWhether or not you think it’s a great rotation, something good seems to be happening in world stock markets—people are buying again. Equities are headed up, and investors seem to be genuinely happy about the prospects for economic recovery in….well, the U.S., at least (can’t yet say the same for Europe, Canada or China).

The recent market rally has also left investors who turned to minimum- or low-volatility products, including exchange-traded funds (ETFs), wondering whether or not demand for those slow and steady stocks—i.e., utilities—is driving prices up too far. It’s a question posed by Barron’s writer Brendan Conway, who last week asked whether or not investor demand was destroying the low-volatility anomaly. This anomaly shows that boring, staid stocks tend to outperform over the long run.

Demand for low-vol stocks has, temporarily, at least, taken the slow and steady out of the equation as investor demand has pushed those stocks to the top of the S&P 500.

The question is, What happens if and when low-vol prices start to decline to more reasonable valuations? Could a bubble be brewing in low-vol ETFs and other products that aim to deliver minimum volatility?

It’s a good question and one that was addressed later in the week by Daniel Morillo, head of investment research at iShares. In an article posted on ETF Trends, he argues that minimum volatility isn’t overbought and that it’s still an effective strategy. Morillo writes that, although the valuation for the MSCI USA Minimum Volatility Index was 8.63x versus 8.16x for the MSCI Index (the comparable cap-weighted index), it doesn’t mean that the former is more overvalued—quite the opposite, in fact. Morillo says profitability is driving the difference.

Close to 75% of the variation in valuation can be explained just by looking at the aggregate profitability level, with every percentage point in additional profitability explaining about two points’ worth of additional valuation. The U.S. cap-weighted benchmark is on the “expensive” side, with a valuation ratio of 8.16x, but this is partly explained by profitability levels higher than that of the average developed country.

Thus, while the minimum volatility index is more expensive than the benchmark, the aggregate profitability is also higher—in short, the underlying stocks are doing better because they are creating value and producing better returns.

There’s certainly more room for research into exactly what is driving profitability—and whether or not investors stay hungry for low volatility, particularly as stocks promise investors some decent upside momentum (that’s the kind of volatility many of us like!). But for plan sponsors that can no longer afford to ride the tide of stocks up and down, low-volatility options are likely to remain a compelling proposition. And there is still ample room to explore low vol in newer areas of the market—emerging markets, for example, where downside volatility is still a big concern in the pension world.

This article originally appeared on our sister site, BenefitsCanada.com.

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