Low Volatility Equities and High Valuations

In 2010 Mercer issued guidance recommending that clients have an explicit allocation to low volatility equities. Since then equity markets have risen significantly, and despite these strong market returns, low volatility equities have kept pace with the broader market. 

This strong (and perhaps surprising) performance does raise some questions:

  • Why have low volatility equities performed so strongly in a sharply rising market?
  • Does this strong performance imply low volatility equities are now overvalued?
  • What will this mean for the ability of low volatility equities to protect value in falling markets?

Every environment is different and it is impossible to know whether low volatility stocks are indeed expensive or whether they will provide the expected protection in the future. Low volatility equities do appear fully valued compared to history and are currently at a premium relative to the broader market. It is possible that if we see a market shock caused by, for example, an interest rate rise resulting in a de-rating of “yield,” we could see low volatility stocks underperform a falling market.

But the current high valuations do not necessarily appear to suggest future underperformance from low volatility equities. Relative valuation levels are not yet at extreme levels. Equally, we have found little evidence that it is possible to “time” the entry into low volatility equities using, for example, a valuation signal. Mercer’s core advice remains that low volatility equities are held as a strategic allocation within an investor’s equity portfolio. Our base case remains that, in stressed environments, we continue to expect low volatility stocks to provide a degree of protection as investors favor the defensive, lowly geared, and stable earnings profiles of low volatility companies.

Attention should always be paid to the entry point valuation when investing in an asset; however, within low volatility equities their defensive qualities could be most needed when valuations across the market as a whole are at their most stretched and the risks of drawdown are at the most significant. To put it another way, if we are concerned that valuations are generally high across all equities, it is probably rational to invest in defensive and stable company with a consistent earnings profile, rather than a highly cyclical company with a volatile earnings profile, even if the former is more expensive.

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