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Monday, June 3, 2013

Is Minimum Value Overvalued ? The Debate Begins

I have some questions about this issue and hopefully will get a chance to write about it. Meantime over at the ishares blog, they make the argument that while minimum value carries a high valuation vs the market cap weighted index (which in my view is highly valued) the valuation is justified given profitability. I'm not so sure.

From the article

 the chart below shows the profitability (measured as Return-on-Assets) as well as the valuations (measured as Price-to-EBITDA) across a range of developed countries [2] as of the end of April. Close to 75% of the variation in valuation can be explained just by looking at the aggregate profitability level, with every percentage point in additional profitability explaining about 2 points worth of additional valuation. The US cap-weighted benchmark is on the “expensive” side with a valuation ration of 8.16x but this is partly explained by profitability levels higher than that of the average developed country.

The chart also shows that the minimum volatility index is indeed more expensive than the benchmark, but the aggregate profitability of the portfolio of companies in the minimum volatility index is also higher than the benchmark. Indeed, the minimum volatility exposure seems better valued in the sense that its higher profitability would justify higher valuations given the observed relationship between valuations and profitability across developed countries

On the other hand....Index Universe takes the other side here e

Hot ETF Topics


When Low Volatility Bites Back
By Elisabeth Kashner | June 03, 2013

Related ETFs: SPLV / USMV / LGL

They ask some very interesting questions. Could it be a case of too short a set of data or is it in this case really "different this time" ?

These analyses are quite sensitive to the time periods chosen. Other analyses, using more variables and longer time periods, have come to different conclusions. But in terms of the simple question, "Could I have done just as well by investing 70 percent of my cash in the S&P 500 and the balance in T-bills?", the answer is a definite maybe.....

And if price reverts to mean valuation this is troubling

So, what explains low volatility's outperformance for much of the past four years?
500 vs low vol: 2006 - 2013
The principle "the observer affects the observed" could be at work here.
Simply put, after the housing crash, playing defense is the new offense, and investors have been piling in. Many portfolio managers have hopped on the defensive bandwagon, adding allocations to high-yielding dividend stocks and to low volatility. In the process, a strange thing has happened to low volatility valuations—they're really not cheap anymore.
As of June 2, 2013, U.S.-focused large-cap and total-market volatility funds have posted some chunky price-to-earnings (P/E) ratios:

Fund/IndexP/E Ratio
MSCI USA Investable Markets Index19.63
MSCI USA Large Cap Index17.48
iShares MSCI USA Minimum Volatility Index Fund (USMV)19.18
SPDR Russell 1000 Low Volatility Fund (LGLV)19.80
PowerShares S&P 500 Low Volatility Fund (SPLV)20.63

Indeed, SPLV's and LGLV's P/E ratios are notably higher than those of their parent index's large-cap universes. To be fair, the Russell 1000 dips well into the midcap space by many definitions, but excludes small-caps. Even compared with the overall U.S. equity market, LGLV looked expensive.
More at index universe here another excellent analysis. The inflows in this strategy have been big:
Low-volatility strategies such as the PowerShares S&P 500 Low Volatility Portfolio (NYSEArca: SPLV) and the iShares MSCI USA Minimum Volatility ETF (NYSEArca: USMV) have been incredibly popular with investors this year. But these funds have started to show underperformance that might sully their appeal.
SPLV is by far an investor favorite. With more than $4.9 billion in assets and average daily trading volume north of $80 million, there’s little question that the fund is well liked by investors
With the big inflows to this and to dividend stocks funds and ETFs it may get ugly as the tide turns.

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