Should You be Worried about a Low Volatility Bubble?

Data analysis has suggested low volatility strategies are less prone to bubbles than traditional market cap-weighted indices.

(December 18, 2013) — Investors in low volatility strategies are unlikely to suffer from a bubble effect due to the low volume of cash invested, according to research from Ossiam.

The provider of smart beta exchange-traded funds and affiliate of Natixis Global Asset Management investigated whether the recent popularity of low volatility strategies could result in a bubble effect, caused by the flow pressure on the prices of companies typically selected by this approach.

Ossiam assessed four measures of “expensiveness” which would be considered a hallmark of an approaching bubble—fund flows, fundamental valuation, relative performance, and whether correlations with other strategies increase.

For each of the criteria, Ossiam’s data suggested that there was no evidence of an abnormal—or bubble-like—behaviour.

“Despite the amount of recent interest in this investment style, the amount invested in this sector is small compared to the market capitalisation of the low risk stocks,” Ossiam said.

“These strategies do not exhibit bubble-like outperformance with respect to the market… the low-risk stock appear somewhat expensive, but the historical analysis reveals that this expensiveness was not generated only recently, but is rather a manifestation of a premium from which less indebted and more profitable companies benefit.”

The research did highlight an increase in correlation however. An earlier experiment by Deutsche Bank’s quantitative team in May 2013 had looked at the crowdedness of low volatility strategies, and found that when investors traded a group of stocks as a basket, i.e. a basket of low volatility equities, they showed higher correlations than a market average, particularly during downturns.

Ossiam’s investigation took the S&P500 universe and built 10 portfolios corresponding to volatility deciles, and measured the average correlations within each during market downturns.

The data found the lowest volatility buckets consistently showed the highest correlations among the volatility buckets. However, Ossiam wasn’t able to conclude that the correlation was driven by money flows into the bucket as it could also be due to the low volatility buckets’ concentration in defensive stocks, such as defence, healthcare, and utilities.

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