23 Oct Low Volatility: Not Just A Utilities Play
by Justin Lowry, CIO, Global Beta Advisors
The misconception that low volatility strategies are simply utilities exposure in disguise has been perpetuated through, what we believe is flawed, low volatility strategies, such as the S&P 500 Low Volatility Index, which selects and weights companies by their individual trailing standard deviation of returns. This approach has led to a long term over exposure to utilities because utility companies tend to be lower growth companies that pay dividends, so the price action in those companies tend to be more muted. However, the popularity of low volatility strategies, such as those that track the S&P 500 Low Volatility Index, have driven up multiples in the utilities sector. The S&P 500 Low Volatility Index has had an average quarterly utilities exposure of 21.73% from 06/30/11 through 08/31/20 (Source: Factset Research Systems). We believe this has been part of the catalyst that has seen the utilities sector, as measured by the S&P 500 Utilities Sector Index, have the largest price to sales multiple expansion (457%) from 12/31/02 through 08/31/20 and the second largest multiple expansion (29.94%) from 08/31/15 through 08/31/20 (Source: Factset Research Systems). How can an investor control volatility without having utilities exposure, which leads to higher valuation and interest rate exposure?
Well, as the saying goes, there’s more than one way to skin a cat, and in this case, it is our view that the old way is the least efficient way. At Global Beta, it is our mission to build customized index strategies to provide investors with factor-based strategies that are nimble and dynamic without overpaying for it. Our Global Beta Low Beta Index looks at stocks in the S&P 500 that have the lowest relative beta to the market and then uses the companies’ revenues to determine their weighting within the index. We believe this combination provides investors with a portfolio that provides robust downside protection while reducing investors’ valuation exposure. Below is a chart of the quarterly utilities exposure over time for the Global Beta Low Beta Index and the S&P 500 Low Volatility Index:
Utilies Exposure Over Time
Source: Factset Research Systems
Consequently, this tactfully reduces prolonged over exposure to utilities. We believe the net result improves the quality and stability of the portfolio. Below is a snapshot of the characteristics between our Global Beta Low Beta Index and the S&P 500 Low Volatility Index, which as mentioned, tracks the aforementioned S&P 500 Low Volatility Index:
|Global Beta Low Factor Index||S&P 500 Low Volatility Index|
|# of Securities||101||101|
|P/E using FY1 Est||17.6||22.0|
|P/E using FY2 Est||16.4||20.3|
|Est 3-5 Yr EPS Growth||9.6||8.7|
Source: Factset Research Systems, as of 08/31/20
As you can see from the above characteristics chart, the Global Beta Low Beta Index has better valuations as measured by nearly every valuation multiple. It even provides exposure to companies with greater expected future EPS growth and larger cap securities, which in our view, enhances stability and liquidity within investors’ portfolios.
The bottom line is that it’s important for investors to be able to tactfully rotate to each relevant factor in the market. When investors allocate to low volatility, they are seeking downside protection, and given the vulnerability that high multiple securities or sectors and interest rate sensitive sectors, such as utilities, can have to corrections; that can leave investors missing their investment objective.