The Underlying Risk in Low-Volatility Portfolios

So-called low-volatility portfolios are an apparent anomaly – they appear to offer higher returns with less risk (volatility). New research shows that they are indeed uncorrelated to sources of macroeconomic risk. But their popularity has driven up valuations, dampening the prospects for future returns.

The superior performance of low-volatility (and the related factor of low-beta) stocks was first documented in the academic finance literature in the 1970s – by Fischer Black (in 1972), among others – even before the size and value premiums were “discovered.” The low-volatility anomaly – lower volatility stocks, with their lower exposure to equity systematic risk, outperformed higher volatility stocks – has been shown to exist in equity markets around the world. Interestingly, this finding is true not only for stocks but for bonds as well. It led academic researchers to dig deeper into the evidence to determine if low volatility/beta is a unique factor.

Is low volatility a unique factor?

Both Robert Novy-Marx’s 2016 study, “Understanding Defensive Equity,” and Eugene Fama and Kenneth French’s 2015 study, “Dissecting Anomalies with a Five-Factor Model,” found that the low-volatility and low-beta anomalies were well explained by asset pricing models that include the newer factors of profitability and investment (in addition to market beta, size and value). And Stefano Ciliberti, Yves Lemperiere, Alexios Beveratos, Guillaume Simon, Laurent Laloux, Marc Potters and Jean-Philippe Bouchaud, authors of the 2017 paper, “Deconstructing the Low-Vol Anomaly,” found that once the common factors of value and profitability were controlled for, the performance of low volatility/low beta became insignificant. They concluded that “although the low-vol (/low-β) effect is indeed compelling in equity markets, it is not a real diversifier in a factor-driven portfolio that already has exposure to value-type strategies. In a nutshell, the dividend yield factor explains (as expected) the dividend part of the low-vol perfor­mance, while the earnings-to-price factor explains the ex-dividend part.”