By Michael Rawson, CFA
Recently, low- or minimum-volatility
have been all the rage. PowerShares S&P 500 Low Volatility(
) and iShares MSCI USA Minimum Volatility(
) have combined to attract $9 billion in assets in less than two
years since inception. SPLVselects the 100 least-volatile stocks
from the S&P 500, and it is touted as a simple way to take
advantage of the low-volatility anomaly. However, there is perhaps
an even simpler way: mega-caps.
For those of you unfamiliar with the low-volatility anomaly, a
short review is in order. In the 1970s, Fischer Black observed that
low-beta stocks, which were less sensitive to the broad market's
gyrations, performed nearly identically with high-beta stocks. This
contradicted a fundamental prediction of the capital asset pricing
model, or CAPM, which was that higher beta equals higher returns. A
number of more recent studies have shined a light on the anomaly,
Benchmarks as Limits to Arbitrage: Understanding
the Low Volatility Anomaly
," by Baker, Bradley, and Wurgler.
This study argues that some investors prefer higher-risk
strategies with the biggest potential upside. How else can we
explain the popularity of lotteries despite the fact that they are
negative net present value investments? Further, institutions such
as mutual funds are restricted in the use of leverage but have
incentive to beat a benchmark, so they seek out high-risk beta
stocks that give the highest potential returns. This results in
high-beta stocks being bid up to the point where future returns are
lower than expected.
A number of ETFs have come to market to exploit the phenomena.
But the recent popularity of low-volatility strategies probably
owes to the fact that investors have been exceptionally risk-averse
since the financial crisis, and low-volatility strategies held up
better during that period. In the four years since the market
peaked in October 2007, the S&P 500 lost a cumulative 11% while
the S&P 500 Low Volatility Index gained 14%.
In the Land of the Giants
Mega-cap stocks are blue-chip companies, international
conglomerates, or firms with strong brands and wide economic moats.
These companies are large for a reason. Their industry dominance
and diversified revenue streams result in more predictable
earnings, which makes their stock prices less volatile. Morningstar
defines mega-caps as those in the top 40% of the cumulative market
capitalization, which currently puts them at $56.8 billion or
greater in market cap. At this cutoff, only about 55 companies
would qualify as mega-cap.
There are a number of mega-cap-themed ETFs, including iShares
S&P 100 Index (
), Guggenheim Russell Top 50 Mega Cap (
), SPDR Dow Jones Industrial Average (
), and Vanguard Mega Cap (MGC). OEF tracks the 100 stocks from the
S&P 500 with liquid options markets. XLG tracks the 50 largest
companies from the Russell 1000, giving it the highest average
market cap at $163.3 billion. DIA tracks the well-known Dow Jones
Industrial Average, a price-weighted index of blue-chip companies.
MGC is the cheapest option, but the CRSP index it follows dips into
large-cap territory, so it has less pure exposure to mega-caps.
(click to enlarge)
Risk and Return
Historically, mega-cap stocks have been somewhat less volatile than
the market overall. The S&P 500 has had a volatility of return
of 15.4% since 2002, while the Russell Top 50 Index has been
somewhat less volatile at 14.8%. While slightly less volatile,
mega-cap stocks do not necessarily benefit from the low-volatility
anomaly. The Russell Top 50 Index had an annualized return of 3.2%
during that period, less than the 4.9% return of the S&P 500.
However, the S&P 500 Low Volatility Index had a much lower
volatility at only 10.5% and a much higher return at 8.6%. So it
seems that a portfolio of stocks built on large size does indeed
have lower volatility but does not have the same outperformance as
a portfolio built by targeting low-volatility stocks
We can examine risk and return going back even further than 2002
by using data from
Kenneth French's website
. He divides all of the stocks in the market into 10 buckets. We
will designate decile 1, which contains the largest 160 or so
stocks, as mega-cap; decile 10, which contains the smallest 1,422
out of 3,551 stocks, will be micro-cap. When plotting the risk on
the y-axis and return on the x-axis, the deciles seem to form an
upward sloping line, with the mega-caps having the lowest risk but
also the lowest return.
(click to enlarge)
Source: Kenneth French.
Taking less risk by investing in mega-caps was rewarded with
less return, confirming the predictions of the CAPM. There is no
anomalous return here. While mega-caps are slightly less volatile
than the broad market, they do not give investors access to the
PowerShares S&P 500 Low Volatility has outsized bets on certain
sectors. Mega-caps are more sector neutral. Compared with
mega-caps, PowerShares S&P 500 Low Volatility is overweight
utilities, consumer staples, and real estate, investing nearly 64%
of its assets in these three sectors compared with just 14% for
Guggenheim Russell Top 50 Mega Cap. That is an overweighting of 50
percentage points. At the same time, PowerShares S&P 500 Low
Volatility is underweight financials, energy, technology, and
health care, which make up 18% of assets compared with 64% for
Guggenheim Russell Top 50.
Low Risk, but Not at Any Price
Clearly, portfolios of less-volatile stocks have a performance edge
over the long run, but is now a good time to invest in this
strategy? Low-risk stocks and those with a high dividend have had
excellent recent returns, but they are beginning to look expensive.
During the past year, PowerShares S&P 500 Low Volatility has
returned 22% compared with 13% for Guggenheim Russell Top 50. That
sort of performance differential is unsustainable.
On a valuation basis, stocks in PowerShares S&P 500 Low
Volatility currently trade at a price/fair value of 1.10, which is
overvalued compared with the 0.96 price/fair value for Guggenheim
Russell Top 50. Price/fair value is our preferred valuation metric,
and it is based on a bottom-up analysis of each portfolio
constituent. Morningstar has more than 100 equity and credit
analysts, and they build detailed cash flow projections on each
company they cover. These projections form the basis of a fair
value estimate that can be aggregate at the portfolio level.
Additionally, stocks in PowerShares S&P 500 Low Volatility
trade at a much more expensive price/forward earnings of 17.4 times
compared with 13.8 times for Guggenheim Russell Top 50. Despite the
cheaper valuations, mega-caps actually have grown more quickly than
low-volatility stocks. Stocks in Guggenheim Russell Top 50 grew
earnings by 11% compared with 7% for PowerShares S&P 500 Low
Volatility. Usually, investors pay more for growth. The fact that
PowerShares S&P 500 Low Volatility has had lower earnings
growth but still trades at a higher price/earnings indicates that
investors are currently paying a premium for the perceived safety
of these stocks.
We like the benefits of the low-volatility strategy, but based
on valuation, a better approach at the current time is to invest in
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