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Low-volatility investing

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Low-volatility investing is an investment style that buys stocks or securities with low volatility and avoids those with high volatility. This investment style exploits the low-volatility anomaly. According to financial theory risk and return should be positively related, however in practice this is not true. Low-volatility investors aim to achieve market-like returns, but with lower risk. This investment style is also referred to as minimum volatility, minimum variance, managed volatility, smart beta, defensive and conservative investing.

History

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The low-volatility anomaly was already discovered in the early 1970s, yet it only became a popular investment style after the 2008 global financial crises. The first tests of the Capital Asset Pricing Model (CAPM) showed that the risk-return relation was too flat.[1][2] Two decades later, in 1992 the seminal study by Fama and French clearly showed that market beta (risk) and return were not related when controlling for firm size.[3] Fisher Black argued that firms or investors could apply leverage by selling bonds and buying more low-beta equity to profit from the flat risk-return relation.[4] In the 2000s more studies followed, and investors started to take notice.[5][6][7] In the same period, asset managers such as Acadian, Robeco and Unigestion started offering this new investment style to investors. A few years later index providers such as MSCI and S&P started to create low-volatility indices.

Performance

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10 portfolios of stocks sorted on volatility: US 1929-2023

Low-volatility investing is gradually gaining acceptance due to consistent real-life performance over more than 15 years, encompassing both bull and bear markets. While many academic studies and indices are based on simulations going back 20-30 years, some research spans over 90 years, showing low-volatility stocks outperform high-volatility stocks in the long run (see image). Since low-volatility securities tend to lag during bull markets and tend to reduce losses in bear markets, a full business cycle is needed to assess performance. Over shorter time periods, such as one year, Jensen's alpha is a useful performance metric, adjusting returns for market beta risk. For instance, a low-volatility strategy with a beta of 0.7 in a 10% rising market would be expected to return 7%. If the actual return is 10%, Jensen's alpha is 3%.

Criticism

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Any investment strategy can lose effectiveness over time if its popularity causes its advantage to be arbitraged away. This could apply to low-volatility investing, highlighted by the high valuations of low-volatility stocks in the late 2010s.[8] Still, David Blitz showed that hedge funds are at the other side of the low-volatility trade, despite their ability to use leverage. Others state that low-volatility is related to the well-known value investing style. For example, after the dotcom bubble, value stocks offered protection similar to low volatility stocks. Additionally, low-volatility stocks also tend to have more interest rate risk compared to other stocks.[9] 2020 was a challenging year for US low-volatility stocks as they significantly lagged behind the broader market by wide margins.[10][11] Criticism and discussions are primarily found in various academic financial journals, but investors take notice and contribute to this debate.[12][13]

See also

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Further reading

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A couple of books have been written about low-volatility investing:

  • Eric Falkenstein, Wiley Publishers 2011, Finding Alpha: The search for alpha when risk and return break down. ISBN 9780470445907
  • Peter Sander, McGraw-Hill 2013, All about low-volatility investing. ISBN 9780071819848.
  • Eric Falkenstein, 2016, The Missing Risk Premium: Why low-volatility investing works. ISBN 1470110970
  • Pim van Vliet, Jan de Koning, Wiley Publishers 2017, High Returns from Low Risk: A Remarkable Stock Market Paradox. ISBN 9781119351054.

References

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  1. ^ Black, F., Jensen, M. C., & Scholes, M. (1972). The capital asset pricing model: Some empirical tests. Studies in the theory of capital markets, 81(3), 79-121.
  2. ^ Fama, E. F., & MacBeth, J. D. (1973). Risk, return, and equilibrium: Empirical tests. Journal of Political Economy, 81(3), 607-636.
  3. ^ Fama, E. F., & French, K. R. (1992). The cross‐section of expected stock returns. The Journal of Finance, 47(2), 427-465.
  4. ^ Black, Fischer (1993-10-31). "Beta and Return". The Journal of Portfolio Management. 20 (1): 8–18. doi:10.3905/jpm.1993.409462. ISSN 0095-4918. S2CID 154597485.
  5. ^ Ang, A., Hodrick, R. J., Xing, Y., & Zhang, X. (2006). The cross‐section of volatility and expected returns. The Journal of Finance, 61(1), 259-299.
  6. ^ Clarke, Roger, Harindra de Silva & Steven Thorley (2006), “Minimum-variance portfolios in the US equity market”, Journal of Portfolio Management, Fall 2006, Vol. 33, No. 1, pp.10–24.
  7. ^ Blitz, David; van Vliet, Pim (2007). "The Volatility Effect: Lower Risk Without Lower Return". Journal of Portfolio Management. 34 (1): 102–113. doi:10.3905/jpm.2007.698039. S2CID 154015248. SSRN 980865.
  8. ^ "How Can "Smart Beta" Go Horribly Wrong?". researchaffiliates.com. Retrieved 2019-07-24.
  9. ^ Baker, Malcolm; Wurgler, Jeffrey (2012). "Comovement and Predictability Relationships Between Bonds and the Cross-Section of Stocks" (PDF).
  10. ^ "Some investors tried to win by losing less-they lost anyway". The Wall Street Journal. 18 September 2020.
  11. ^ Wigglesworth, Robin (2021-03-22). "A fallen star of the investment world". www.ft.com. Retrieved 2021-09-15.
  12. ^ Hamtil, Lawrence (2019-07-22). "Compendium of Low Volatility Articles". Fortune Financial Advisors. Retrieved 2019-07-24.
  13. ^ Swedroe, Larry (2018-07-12). "Deconstructing the Low Volatility/Low Beta Anomaly". Alpha Architect. Retrieved 2019-07-24.
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