When Low Volatility Bites Back

As my colleague Ugo Egbunike and I pointed out in our blog 'Why Low Volatility Is Losing Its Alpha,' SPLV had a bad week on the heels of serious corrections in high-yielding utilities stocks.

Returns of the PowerShares S&P 500 Low Volatility Portfolio (NYSEArca:SPLV) versus those of its parent index, the S&P 500, suddenly look unappealing. After a long run of outperformance, low-volatility funds have fallen out of bed with a thud.

The telltale sign of a bubble?

The hallmark of low volatility is underperformance during market bubbles, and outperformance when the bubbles burst.

The chart below shows the rolling 12-month returns difference between the S&P Low Volatility Index and its parent, the S&P 500 index.

The low-volatility strategy took it on the chin during the Internet bubble, but delivered in spades after the dot-com bust, only to drop again after the market bottom in 2002. Low volatility was a good refuge during the housing bubble crash, but lagged badly during the initial phase of the recovery.

The recent underperformance of low vol might signal the onset of another market bubble.

The principle 'the observer affects the observed' could be at work here.

Simply put, after the housing crash, playing defense is the new offense, and investors have been piling in. Many portfolio managers have hopped on the defensive bandwagon, adding allocations to high-yielding dividend stocks and to low volatility. In the process, a strange thing has happened to low volatility valuations-they're really not cheap anymore.

As of May 2, 2013, U.S.-focused large-cap and total-market volatility funds have posted some chunky price-to-earnings (P/E) ratios:

Indeed, SPLV's and LGLV's P/E ratios are notably higher than those of their parent index's large-cap universes. To be fair, the Russell 1000 dips well into the midcap space by many definitions, but excludes small-caps. Even compared with the overall U.S. equity market, LGLV looked expensive.

This wasn't always so.

Historically, low-volatility portfolios have carried low P/E ratios-so much so that academics have argued about whether low volatility is a separate anomaly from the value effect, or if they are two sides of the same coin. Could the recent uptick in low-volatility P/Es be a telltale sign of a low-volatility bubble?

Is low volatility, in fact, just low volatility?

Low volatility could just be doing its job, which is to reward investors during volatility spikes.

Take a look at this chart, which superimposes the 12-month rolling difference in returns to the S&P Low Volatility strategy versus the S&P 500, and the trailing 30-day realized volatility of the S&P 500 index:

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.