Recently a friend of mine sent me an e-mail after my review of Eric Falkenstein’s latest book. Here it is:
David, I’ve been reading a decent amount of the academic literature on low vol investing and it’s certainly got my attention. I’ll definitely be purchasing his book to read thru it, but I think he and Mebane Faber have had quite a bit of this stuff on their respective blogs. Frankly I liked the research enough that I decided to part ways with some gifted Verizon stock that the in-laws gave us and bought a global low-vol ETF (ACWV).
I wish it had a bit more international tilt, but there is a sister international ETF that I can buy, so I might add that at some point to balance out the geographic exposure. The one thing that really surprised me the most was that I figured this thing would have huge weights in Utes/Telecom. Not so–actually the industry diversification looks very attractive. And for 35bps of fees vs nearly 4% yield, hard to go wrong with this product for a nice LT buy and hold. Kinda funny when I find myself, as a stock guy, actually liking a highly diversified index-type product… I just needed a bit more balance in the portfolio from all my very idiosyncratic idea.
Some of your readers might be interested in some of these ETFs if you think they are worth talking about.
For raw quantitative index investing, funds like these are good ideas, at least for now. But with all new strategies, I ask the question, what will happen when a lot of people do this? It is possible for stocks that minimize volatility as a group to become overpriced.
Think about what a minimum volatility portfolio looks like. The companies pay decent dividends, are mostly not in cyclical industries… the portfolio looks like growth at a reasonable price. Company financial & operating leverage is relatively low. When I think of all of these together, it sounds like high free cash flow, and/or high growth of free cash flow. This would be similar to high-quality growing companies that don’t take on a lot of debt.
A minimum variance portfolio, should the portfolio characteristics continue over the rebalancing horizon, will behave somewhat like a high yielding bond, but noisier.
The fund that my friend mentioned has an above average P/E ratio, an above average dividend yield, and an above average Price-to-Book ratio. It tends to choose stable, eclectic companies within each economic sector. For example, when I looked at financials, I saw a disproportionate amount of REITs, Insurers, and obscure Japanese and Asian banks.
This is a little quirky, but the stable elements of a variety of different sectors seem to do well over time as a portfolio. But just as “value stocks” as a group can become overvalued, the same can happen for the stocks in the minimum volatility portfolio. It would be good to track the average E/P & B/P (trailing twelve months) for the portfolio. If the valuation metrics get too high, it could be a sign that low volatility is becoming a crowded trade.
That said, given the dynamism inherent in re-estimating a minimum variance portfolio, it might not be so obvious when low volatility is over-invested. Maybe watching when the ratio of the Morgan Stanley Cyclicals index versus the S&P 500 (INDEX.INX) might give us a negative clue. It was less attractive to invest in stable stocks in August of 2000 and February 2009. These are two very different dates. The former showed stable stocks peaking, while the latter was cyclical stocks troughing.
My own investing methods rely on no one factor, but looks at what makes a stock valuable through multiple lenses. But tonight I highlight low volatility, because I think that investors do occasionally overpay for quality, but in general a quality bias pays off over time, as does a value bias.
By David Merkel, CFA of alephblog