While by some metrics low volatility stocks appear richly valued today, low volatility strategies are still relevant to many investors and can play an important role in portfolio construction.

Recent headlines suggest that institutional investors are embracing low volatility strategies and driving up valuations. Some metrics that have people worried include:

• Expensive valuations. As of June 30, 2015, the price-to-book (P/B) ratio for the MSCI USA Minimum Volatility Index traded at an 11% premium to the MSCI US Index and a 6% premium relative to its historical median P/B since 1999.
• Strong asset flows. As of March 31, 2015, eVestment categorized roughly $140 billion as invested in such product and we estimate another $20 billion is invested in ETFs. This compares to under $10 billion circa 2008.
• High sector valuations. Low volatility products have been traditionally overweight utilities—a sector that has also seen strong interest from investors looking for yield. The current P/E for the sector is 15.8, compared to its historical average of 14.6 (an 8% premium).

Claims that the increase in low volatility assets has pushed prices upward are dubious, given that low volatility assets account for less than 1% of the trillions invested in market cap–weighted traditional indexes—indexes which have seen even higher asset flows over the past several years. Additionally, the naive low volatility indexes—which are the basis for most investors’ valuation concerns—are not the ideal instrument to achieve the anomaly’s biggest benefits, as their construction does not differentiate between expensive and cheap stocks.

Despite these and other metrics cited in the press today, low volatility strategies are still relevant to institutional investors, particularly those that are unable to invest in hedge funds. Academic studies have demonstrated that low volatility stocks have historically produced returns commensurate with the broad equity universes over a full market cycle, while providing lower volatility, a superior risk/return profile, and protection in market downturns. (For more on this topic please see our September 2014 report Alternative Beta Strategies: A “Smarter” Way to Invest in Equities?)

Investors considering an allocation to a low volatility strategy should keep several things in mind.

Active management. Investors should consider active low volatility managers rather than naïve low volatility benchmarks, as active managers should be able to avoid the most overvalued low volatility stocks while meeting overall objectives. Cambridge favors active low volatility managers that take into consideration other factors such as valuations, momentum, quality, and interest rate risk, thereby achieving the preferred risk/return profile through several market cycles.

Buy and hold. The minimum variance anomaly capitalizes on investors’ behavioral biases, but, like any other factor, it can be susceptible to faddish popularity and will undergo periods of underperformance. For example, low volatility stocks underperformed the market for several years during the 1990s technology bubble. Paying attention to prices is worthwhile, but picking the best time to buy or to sell can be a loser’s game. If an investor’s goal is to achieve the highest Sharpe ratio and diversify risk, then a low volatility strategy is an excellent addition to a portfolio for the long run—if the investor buys, holds, and rebalances consistently.

Alternative defenses. Outside of low volatility, investors seeking to become more defensive have other ways to do so. Call writing option strategies, which we wrote about in our 2011 paper The Benefits of Selling Volatility, are becoming more popular because of their transparency, efficiency, and low fees. Many active equity managers also maintain a highly defensive posture by holding high levels of cash or other instruments such as options or convertibles.

While low volatility stocks may appear to be richly valued, we believe low volatility strategies can continue to play an important role in investors’ portfolios. Some of the valuation risk can be mitigated by selecting active managers that pay attention to this and other market risks. But to achieve the expected high long-term risk-adjusted returns promised by these strategies, investors must be committed to maintaining an investment in the strategy over all market cycles, despite expected periods of cyclical underperformance—as is the case with most investment strategies.

Deborah Christie is a Managing Director on the Cambridge Associates Global Investment Research team.