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In my last blog, I outlined the difficulty of valuing factors by traditional price metrics such as price-to-earnings and price-to-book ratios. Part of the problem in valuing factors is that factor-based portfolio holdings change so often and can be influenced by market conditions. I would like to expand on that idea by suggesting that market conditions can actually be a predictor of factor performance. In this case, I’d like to examine the low volatility factor.
Low volatility doesn’t adhere to traditional valuation theories
In my discussions with clients, some have questioned whether certain factors might be overvalued. Their concerns arise because — in theory at least — an asset’s valuation should be a strong predictor of future returns. Thus, if valuations are expensive, future excess return should conceivably be negative, while if valuations are inexpensive, future excess returns should ostensibly be positive. In other words, there should be some type of inverse linear relationship between valuation and excess return.
But this theory doesn’t always hold when it comes to factors. Consider Invesco’s flagship low volatility portfolio: Invesco S&P Low Volatility ETF (SPLV). The graphic below represents an equal weight composite of SPLV’s expected price-to-earnings, expected price-to-sales and price-to-book ratios against the S&P 500 Index over a five-year period. (Since valuations have tended to expand since the 2008 financial crisis, it is important to measure valuations against a benchmark like the S&P 500.) When the values on the x-axis are above 0, SPLV was expensive; when they are below 0, SPLV was inexpensive. The y-axis illustrates outperformance and underperformance of SPLV versus the S&P 500 Index.
In the graphic below, note where periods of expensive/outperformance and inexpensive/underperformance lie relative to the grey sloping line in the middle, which represents the inverse relationship between valuation and excess returns that we would expect to see.
Contrary to intuition, the graphic indicates that SPLV has periodically outperformed in periods when it was expensive relative to the S&P 500 Index and has underperformed in periods when it was cheap relative to the S&P 500 Index. Why is this? One explanation may be that the market bids up low vol’s premium for downside risk mitigation potential when the equity market is under stress. Conversely, the market may sell the downside risk mitigation premium when the market is strong. Thus, low volatility may appear expensive when it is likely to “pay off,” and appear inexpensive when its risk mitigation properties are less desirable.
Market environment can be a strong predictor of low volatility performance
Although the low volatility anomaly is present across market cycles, the performance of the low volatility factor has historically varied over the near term and has been heavily influenced by market conditions. More specifically, low volatility has historically tended to generate excess returns when the equity market was falling and has underperformed when the equity market was rising. In the charts below, SPLV’s excess return relative to the S&P 500 Index is shown on the y-axes, while relative the performance of the equity market itself, as represented by the S&P 500 Index, is shown on the x-axes.
Low volatility has outperformed in stressed market environments
Note the inverse linear relationship in the first chart. The stronger the equity market (reflected by the performance of the S&P 500 Index), the weaker the excess return of SPLV, and vice versa. In this case, the return of the S&P 500 Index explains about 58% of the variation in SPLV’s excess return. This statistical analysis indicates that the market’s direction is a much bigger predictor of SPLV’s performance than valuation.
Credit spreads, too, can explain the excess return of SPLV relative to the S&P 500 Index. The second chart displays the change in high yield credit spreads, as defined by the BarCap US Corporate High Yield Yield to Worst minus 10-year Treasury Yield Spread Index. Rising credit spreads tend to be consistent with increased market risk and stressed market conditions, while falling credit spreads tend to indicate a favorable environment for risk taking. When high yield spreads have risen, SPLV has historically generated excess return, and vice versa. Notice that the change in high yield spreads explained roughly half of the SPLV’s excess return — much more than valuation explains.
When analyzing factors, consider market conditions, rather than valuations
Investors interested in understanding factor performance should understand that the market environment may trump valuations in explaining shorter-term factor performance. Changing portfolio compositions makes factor valuation difficult to pinpoint, while the differentiated risk-return characteristics of a factor portfolio can allow for the market environment to affect short-term performance.
Blog header image: science photo/Shutterstock.com
SPLV Standardize Performance; 0.25% Total expense ratio
Performance data quoted represents past performance. Past performance is not a guarantee of future results; current performance may be higher or lower than performance quoted. Investment returns and principal value will fluctuate and Shares, when redeemed, may be worth more or less than their original cost. See invesco.com to find the most recent month-end performance numbers. Market returns are based on the midpoint of the bid/ask spread at 4 p.m. ET and do not represent the returns an investor would receive if shares were traded at other times. Fund performance reflects applicable fee waivers, absent which, performance data quoted would have been lower. Returns less than one year are cumulative.
The BarCap US Corporate High Yield Yield to Worst minus 10-year Treasury Yield Spread Index, which displays the yield spread between a portfolio of high yield notes as defined by Barclays Capital and the 10-year Treasury yield, measures risk in the high yield market. An investment cannot be made into an index.
Credit spread is the difference between Treasury securities and non-Treasury securities that are identical in all respects except for quality rating.
Price-to-book ratio is calculated by dividing the market price of a stock by the book value per share.
Price-to-earnings ratio measures a stock’s valuation by dividing its share price by its earnings per share.
Price-to-sales ratio is a valuation metric calculated by dividing a company’s market capitalization by its total sales over a 12-month period.
Factor investing is an investment strategy in which securities are chosen based on certain characteristics and attributes.
There are risks involved with investing in ETFs, including possible loss of money. Shares are not actively managed and are subject to risks similar to those of stocks, including those regarding short selling and margin maintenance requirements. Ordinary brokerage commissions apply. The fund’s return may not match the return of the Underlying Index. The fund is subject to certain other risks. Please see the current prospectus for more information regarding the risk associated with an investment in the fund.
Investments focused in a particular industry or sector are subject to greater risk, and are more greatly impacted by market volatility, than more diversified investments.
The fund is non-diversified and may experience greater volatility than a more diversified investment.
There is no assurance that the fund will provide low volatility.
Shares are not individually redeemable and owners of the Shares may acquire those Shares from the fund and tender those Shares for redemption to the fund in Creation Unit aggregations only, typically consisting of 10,000, 50,000, 75,000, 100,000 or 200,000 Shares.
Senior Equity Product Strategist
Nick Kalivas is a Senior Equity Product Strategist representing Invesco’s exchange-traded funds (ETFs). In this role, Nick works on researching, developing product-specific strategies and creating thought leadership to position and promote the smart beta* equity line up.
Prior to joining Invesco, Mr. Kalivas spent the majority of his career in the futures industry, delivering research, strategy and market intelligence to institutional and high net worth clients centered in the equity and interest rate markets. He was a featured contributor for the Chicago Mercantile Exchange, and provided research services to a New York-based global macro commodity trading advisor where he supplied insight on equities, fixed income, foreign exchange and commodities. Nick has been quoted in the Wall Street Journal, Financial Times, Reuters, New York Times and by the Associated Press, and has made numerous appearances on CNBC and Bloomberg.
Nick has a BBA in accounting and finance from the University of Wisconsin – Madison and an MBA from the University of Chicago Booth School of Business with concentrations in economics, finance, and statistics. He holds the Series 7 and Series 63 registrations.