The market environment since the Brexit “V” bounce has been odd, with correlation breakdowns occurring amid an incredibly tight S&P trading range most of the summer. Market volatility, as measured by the CBOE VIX index, is near lows – odd, particularly given the numerous identifiable market risks known to participants.

In this environment the Nomura Quantitative Investment Strategy team wants to understand why low volatility stock selection has worked so poorly during a market environment of  low volatility. They consider the popular notion — crowding in to low volatility stocks has led to over valuation. But in the end they point to a correlation analysis between two polar opposite stock categories, both of which are based on risk and volatility.

Nomura 8 31 Figure 1

Two stock categories based on price volatility and risk

There have been two stock categories not defined by the products or services they provide, but by how their stock volatility profile make-up is constructed.

Stocks that do not exhibit a high degree of price differential, low volatility stocks, had been a significant want among portfolio analysts who view the picks as conservative.

While low volatility stocks have generally done well, something happened after the Brexit vote. In a report titled “Brexit Broke It,” Joseph Mezrich along with a team five additional Nomura quant analysts consider the fate of low volatility stocks, underperforming the market by 3.8% since June.

To conduct analysis they consider a polar opposite: high default risk stocks. In the end, valuation is a key when understanding pricing models and patterns, but Nomura suggests that other factors lead to the underperformance phenomena.

Nomura 8 31 Figure 2

The common assumption is that low volatility stocks have underperformed based on high valuations

The Nomura team explains that the most common reason why low volatility stocks may be underperforming, due to their high valuation, was not the primary performance driver behind low volatility underperformance since Brexit.

“There is a more satisfying explanation that can better account for the poor performance of low-volatility stocks this quarter,” the report observed. “The key takeaway here is that low volatility investing is yet another factor strategy that is affected by the market’s attitude toward reward or punishment of company default risk.”

Another category of stocks not devised based on products or services is the high default risk category. These are stocks on the edge of solvency, a mathematical state of financial affairs that can be benchmarked and identified. Nomura tracks this category and notes a correlation.

With default risk being a major theme in the market, the category has traded higher of late with low vol trading lower. When investors find value in high default risk stocks they are expressing a risk-on approach to markets. “The market’s attitude toward companies with high-default risk has been a key dynamic of the market this year: risk-off has been followed by risk-on,” the report stated.

The Brexit changed this, the report notes, as a correlation factor between low volatility and high risk stocks is identified as part of a cyclical pattern:

The period around the Brexit vote caused a sharp but brief risk-off market drop, but since June 28 risk-on has been back in force, perhaps in pause mode lately. Intuitively, we would expect that, when the market is in risk-on mode, low-volatility stocks would be less favored. Conversely, in a risk-off context, low-volatility stocks would likely be preferred. It is useful to look at the performance of the low-volatility stocks in terms of how the market rewards high-default-risk companies, i.e., the high-default-risk basket return displayed in Fig. 1. Fig. 2 shows relative return of the MSCI US Minimum-Volatility ETF to the S&P 500 (white line) and the inverse of the high-default-risk basket (green line) since the end of June. In this chart, when the green line drops, the market rewards high-default-risk companies and vice versa. The post-Brexit risk-on market rally commenced on June 28. On this date, the market also started to reward high-default-risk companies (the green line in Fig. 2 drops) and began to punish low-volatility stocks (the white line in Fig. 2 also drops). Note the close co-movement of the two series thus far in the third quarter.

Nomura 8 31 Figure 3 default risk

Look at the correlation with risk-on and risk-off and recognize this pattern might not repeat

The stock market has always had a risk-on, risk-off attitude. Nomura points to an essential correlation between risk-off and low volatility. But then mentions periods of time exist when no correlation exists.

To recognize the cycle better, Nomura considers the relationship between high default risk stocks and minimum volatility.

Based on this correlation analysis, the report concludes low-volatility strategies have underperformed post Brexit due to the market rewarding high-default risk.

Will this value behavior persist? Nomura thinks not:

This is yet another example of the impact of default risk on factor returns. Whether low volatility stocks are expensive seems much less relevant. Given the role of default risk in “contaminating” factor performance, we would expect low-volatility stocks to outperform in the next risk-off episode.

Nomura 8 31 Figure 4