Episode Summary
Executive Summary: The episode examines quality and low-volatility as investment factors, explaining how they fit factor-investing principles, why their premiums are harder to justify than value or momentum, and how they may be best used as complements to other factors rather than stand-alone strategies. The hosts agree both have strong long-term evidence, but their explanations are more behavioral than risk-based and less convincing out of sample.
Main Topics: What makes a valid investment factor (Priority: 5/5): The hosts review the standard factor criteria: persistence, pervasiveness, robustness, investability, and logical explanation through risk or behavior. Quality as a factor (Priority: 5/5): Quality is framed as investing in strong businesses with durable profitability, strong margins, efficient capital use, and balance-sheet strength, but the definition is hard to standardize. Why quality is difficult to explain academically (Priority: 4/5): The discussion argues quality lacks a clear risk premium or strong mispricing story, unlike value or momentum, making its future efficacy harder to defend theoretically. Low volatility definitions and mechanics (Priority: 5/5): Low vol is explained using standard deviation and beta, with beta incorporating how stocks move relative to the market rather than just standalone volatility. Why low volatility may work (Priority: 4/5): The main behavioral explanation is that investors without leverage bid up high-beta stocks, leaving low-volatility stocks underpriced; the hosts note this is weaker than the case for value. Overlap with value and quality (Priority: 4/5): The episode suggests low volatility may partly reflect a blend of cheapness and quality, and that some value metrics embed quality exposure. Practical portfolio use (Priority: 5/5): The hosts conclude quality and low vol are best used in combination with other factors, especially value, rather than as the only screen for stocks.
Key Arguments: Quality and low-volatility factors have strong long-term empirical support, even if their economic explanations are less compelling than value or momentum. A true factor should be persistent, pervasive, robust, investable, and logical; quality and low vol satisfy the data tests but are weaker on logic. Quality is usually associated with profitable, stable firms with high margins, high ROE, high ROIC, low leverage, and consistent earnings growth. The main issue with quality is that investors often recognize it and may bid prices up, which creates a harder-to-defend return premium story. Low volatility is challenging to justify via risk because lower-vol stocks are, by definition, not taking more risk than the market. The best behavioral case for low vol is leverage constraints: investors chase high-beta stocks to boost returns when they cannot use leverage. Some of the low-vol return premium may actually be explained by a combination of cheapness and quality rather than pure volatility exposure. Quality and low vol may be more useful as portfolio complements, filters, or components of multi-factor strategies than as standalone bets. Many real-world value strategies already embed quality, so the benefits may come from combined factor exposure rather than a single signal.
Data Points: Factor criteria: 5 characteristics - The hosts list persistence, pervasiveness, robustness, investability, and logical explanation as standards for a factor. Quality definition from AQR: 6 traits - Low earnings volatility, high margins, high asset turnover, low financial leverage, low operating leverage, and low stock-specific risk. Buffett-style quality screen: 3 criteria over 10 years - Consistently high earnings growth, high ROE, and high return on total capital are used as a quality framework. Sector history examined: 1967 to 2009 - Referenced from O'Shaughnessy’s What Works on Wall Street to discuss sector performance and volatility. Consumer staples ranking: Best performing sector over the period - Used as an example of how stable, low-vol businesses can outperform over time. Utilities volatility ranking: Second least amount of volatility - Mentioned as the sector with the lowest volatility in the referenced study.
Pivotal Quotes: "There should be some sort of pain you're enduring to follow the factor from a risk-based perspective." — Jack Forehand: Explaining the academic requirement that a factor must have a risk or behavioral reason for its premium. "It clearly does work, but it's much more difficult to come up with a reason why people might misprice these securities." — Justin Carboneau: Summarizing the central challenge with quality and low volatility as factors. "I believe that a cheap quality portfolio will act similarly to a low vol beta portfolio most of the time." — Wes Gray (quoted by the hosts): Used to support the idea that low volatility may overlap substantially with value and quality.
Implications: Investors should treat quality and low vol as useful but imperfect factors, ideally paired with value or momentum. Their strongest role may be in improving portfolio construction, not in serving as standalone sources of alpha.
From the Transcript
Yeah, so every factor should have, at least from an academic perspective, should have either a risk-based explanation or a behavioral-based explanation. So there should be some sort of pain you're enduring to follow the factor from a risk-based perspective. And from a behavioral perspective, there should be some reason that people would misprice these securities, and I can take advantage of this mispricing. And so when you take a step back and look at value and momentum, those explanations are pretty clear. And we've talked about those in other podcasts. When you get into quality and low volatility, it becomes a little bit more. challenging. I mean, there's no question in the data that both quality and low volatility work over the long term, but trying to explain why they work is much more difficult. So for example, am I really taking more risk by buying a bunch of high quality companies? Probably not. You know, am I taking more risk by buying low volatility companies? By definition, I'm not. And so, and is there a reason people would misprice these stocks? We'll get into it as we talk about each one, but there's not as easy of an explanation as to why people would misprice these.
And that goes back to the original point, which is it's much harder to do, it's much harder to explain why quality works. It clearly does work, but it's much more difficult to go into to come up with a reason why people might misprice these securities. Yeah, and maybe just the last point on this quality thing is, and Wes talked, we just interviewed Wes Gray last week for our podcast. And one of the things that he talked about is you get some quality exposure through some of these value metrics. So, you know, you might, if you use like price to cash flow or you know other types of value metrics that incorporate sort of a quality component in them. I mean, high cash flow is typically associated with high quality firms, you know, you get this quality, you get this embedded quality exposure to some extent through some of these profitability-based value metrics. Yeah, it's the ones that get at the earnings power of the company. So something like price to cash flow or price to earnings, there's an embedded quality in there. Whereas something like price to book, there's actually
He also talked about how low volatility may be a function of combining cheap stocks with quality. And so his quote was, I believe that a cheap quality portfolio will act similarly to a low vol beta portfolio most of the time. So setting aside Minutia arguments, I think it is probably close to six of one, half a dozen of the other. However, I fundamentally believe in the risk behavior arguments underlying value over the arguments underlying low volatility. And so what he's getting at there is maybe low volatility, maybe there's some other things explaining why low volatility. works. Maybe it is a blend of quality and value that works. And Larry Swedrow has talked about this a little bit too. He's talked about how if you look at the excess return of low volatility over the long term, the vast majority of that excess return comes when it was cheap. So a lot of that excess return and low volatility is coming at a time where low volatility and value sort of came together. So that could be an explanation as well. What do you think from a more just practical standpoint, what should be sort of
About Excess Returns
Excess Returns is dedicated to making you a better long-term investor and making complex investing topics understandable. Join Jack Forehand, Justin Carbonneau and Matt Zeigler as they sit down with some of the most interesting names in finance to discuss topics like macroeconomics, value investing, factor investing, and more.