The price-to-book ratio of a generic, low-volatility strategy has become relatively high again, and some investors are worrying about expected performance in such an environment.

In our white paper, link below, we address such concerns using an extended 82-year sample for the US stock market.

Firstly we compare the performance of a generic low-volatility strategy to a market index, finding that sometimes it exhibits value characteristics (1990s) and sometimes growth (1930s).

Large style differences exist between low-vol stocks, strengthening the case for enhancement: performance increases when valuation and sentiment factors are added to a generic low-vol strategy.

The P/B ratio can be used as a predictive signal. Based on this multiple, the generic low-volatility strategy is ‘growth’ (high P/B) 38% of the time, and ‘value’ (low P/B) 62% of the time.

When a generic low-volatility strategy is expensive (high P/B), it proves effective in lowering risk, although it underperforms the market. The addition of valuation and sentiment factors improve the average returns of a generic low-vol strategy by up to 6% a year.

A generic low-vol strategy has slightly higher returns at much lower risk than an index, resulting in a better return/risk ratio. These findings are based on an 82-year sample for the US stock market. Such an extensive period has been chosen because a long-term perspective is required.

We compared the cap-weighted stock market index with a generic low-vol strategy based on historical three-year stock market volatility. Over the 82-year period, the generic low-vol strategy has slightly higher compounded returns compared with the market cap-weighted index (10.1% versus 9.1%).

The risk of a low-vol portfolio is much lower (14.2% versus 18.3%), which translates into a better return/risk ratio (0.71 versus 0.50). The risk-adjusted outperformance (CAPM alpha) is 3.7% per year, in line with previous studies of the low-volatility anomaly.

A mixed picture
While a generic low-vol strategy sometimes exhibits value characteristics (1990s) and sometimes growth (1930s), this can change significantly over time, varying from value to growth and back, although it also depends on which measure is used. Nowadays it is a mixed picture: low-volatility is growth based on P/B, and is value based on dividend yield.

Not all low-volatility stocks are equal and a wide dispersion exists based on different valuation multiples. Therefore, we believe a generic low-vol strategy should be enhanced by including valuation and sentiment factors.

An enhanced low-vol strategy, which includes valuation and sentiment factors, yields a much better return/risk ratio than a generic low-vol strategy and is necessary to achieve superior long-term returns. The table below shows the long-term statistics and characteristics of this enhanced low-vol strategy.

The enhanced low-vol strategy has more favourable multiples. We find the average return could be enhanced by 3.6%-13.7%, at the cost of somewhat more risk. As a result, the return/risk ratio further improves from 0.71 to 0.88, and the alpha goes up sharply from 3.7% to 6.6%.

We split the historical sample into two groups, relatively low and high P/B, and measured future returns of the market index, generic low-vol strategy and the enhanced low-vol strategy.

We have seen that the P/B of low volatility is time-varying. Based on this multiple, the generic low-volatility strategy is ‘growth’ 38% of the time (high P/B) and ‘value’ 62% of the time (low P/B). The table below shows the statistics based on a relative P/B split.

When generic low-volatility has a relatively high P/B, enhancement pays off significantly. The return and alpha increase by up to 6% compared with a generic low-vol strategy. In this environment, generic low-volatility does not outperform the market on a total return basis (10.8% vs 12.2%), but it does outperform on a risk-adjusted basis (0.70 vs 0.60).

Interestingly, equity markets become more volatile when generic low-volatility has a relatively high P/B. This has been the case historically, but we have also experienced it more recently (2008-2012).

When markets are volatile, low-vol investing proves effective to decrease risk. However, to achieve a superior long-term return, valuation/sentiment factors are needed to enhance a generic low-volatility strategy.

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