It happens time and again – a strategy catches fire in the marketplace, investors rush in to get a piece of the action, and before you know it, the crowd has driven valuations to all-time highs and depleted capacity, burning the strategy out and potentially driving future underperformance. Naturally, given that this could be the generic lifecycle of any strategy du jour, the fear of this scenario rings true for a low volatility strategy as well.
However, the threat of factor crashes from expensive valuations is based on an overgeneralization that all low volatility strategies are created equal – they are not! The long-term relative performance of low-volatility strategies in volatile markets has less to do with valuation and more to do with the degree of risk reduction and alpha source (if any) of the strategy.
Risk and valuations do not have a direct relationship and – this may surprise many investors – attractive valuations do not generally protect against volatility. So what is the relationship between risk and valuations? We illustrate the relationship in a recent white paper on page 3. As shown, attractive valuations do not materially reduce volatility in periods when value stocks exhibit higher market risk as seen over a variety of time periods. Therefore, a valuation-unconstrained low volatility strategy may tend to favor, alternately, growth or value stocks, depending on the changing nature of the volatility environment of the market in order to achieve the goal of minimizing risk.
So, can a low volatility strategy still provide value in the presence of high valuations? Absolutely! Find out more about how low-volatility strategies demonstrate the ability to add value over time despite periods when they have faced heightened valuations in our paper.