We believe that the recent underperformance of Low Volatility stocks has further to
run. With valuations at historical extremes, and positioning still overweight, a turn in
inflation could prompt a further rotation from Low Vol stocks into Value stocks.
Low Vol – Anomaly or Bubble? While many have suggested that Low Vol investing
represents an anomaly that consistently delivers alpha, our work suggests otherwise. The
post-2000 outperformance of Low-Vol appears more driven by these stocks getting
expensive (multiple re-rating) rather than superior earnings growth or other behavioural
factors. Longer term data highlights that like most other strategies, Low Vol stocks too
have suffered periods of significant underperformance, especially when valuations have
been as extremely expensive as is the case today.
It’s not just a call on Staples: The expensiveness of Low Vol stocks persists even after we
control for sector weightings. Within several sectors, particularly Discretionary, Financials,
Telecoms, Staples and Healthcare, we find that investors are paying a high premium for
Low Vol stocks. We have provided sector level charts in the Appendix.
Pricing in deflation: Capital structure effects have seen Low Vol stocks rerate as bond
yields have declined. Diving deeper, we find that inflation (and not real interest rates) has
been the dominant driver of Low Vol performance. Today Low Vol stocks appear to be
pricing in deflation in developed economies. However, the spectrum of factors we analyse
suggests a recovery in inflation in 2017.
Prefer Value to Low Vol: Both on the Passive and the Active side, investors appear to be
heavily exposed to Low Vol stocks. Therefore, with inflation potentially accelerating, the
rotation out of Low Vol stocks into Value stocks could be severe (baskets in the
Appendix). Sectorally, Banks, Autos and Insurance stocks continue to trade near P/E lows
despite positive EPS revisions. We add UBS to our European Recommended Portfolio.