Now Is Not The Time To Value-Tilt Low Vol
Eric Falkenstein | Aug 12, 2013 01:52AM ET
Every week, a low volatility researcher has the same epiphany: tilt low volatility towards value. This addresses two pressing issues simultaneously: avoiding overbought securities and adding value alpha.
A neat articulation of this view is from Feifei Li of Research Affiliates, this Excel spreadsheet (there's nothing proprietary going on here). So here's that average number calculated each month, and the total return on French's value factor (aka, HML, or High-Minus-Low factor portfolio proxy).
Clearly the low average decile corresponds to big increases in the HML factor returns. If I take that time series, and put the data into deciles, I get a pretty clear pattern for future HML returns:
Basically, the value (ie, HML) factor only pays off when the average book/market decile is in the bottom third of its distribution. Alas, we're not there, we are around the 70th percentile right now. So, here's the average return for the value factor, for that 50% of the time when the average book/market decile is above average (ie, now):
That line is sloping the wrong way if you are banking on a value premium.
In sum, loading up on the value factor to improve low volatility is dangerous because 1) the relation between book/market and returns not linear, so simple portfolio averages can be misleading and 2) the value premium can be predictably predictable given the distribution of the market across book/market deciles.
In practice, the value premium to passive indices seems about 1-2% since it was popularized around 1990. The 2.8% HML premium from 1928-2013 is do a lot to shorting low book/market stocks, a premium with dubious feasibility, so this number is not a good rule of thumb for the value of tilting towards value. Value ETFs like IWD arose fortuitously around 2000, and so their 3% annual outperformance is all from the bursting of the internet bubble--if those value ETFs went back to 1990, the return premium would be less. I would estimate there's 100 basis points in the value factor, yet, that's by itself. When you try to use value to add to other strategies, it's not obviously beneficial, and most low vol practitioners are doing this, so you really aren't thinking outside the box.
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