Beware of Low-Volatility Portfolios

Low-volatility strategies are often cited as an anomaly offering higher returns without a corresponding increase in risk. But the so-called low-volatility factor is well explained by other factors, and new research shows it does not reduce exposure to “systemic,” broad-economic risks.

The superior performance of low-volatility (and the related factor of low-beta) stocks was first documented in the literature in the 1970s – by Fischer Black (in 1972), among others – even before the size and value premiums were “discovered” In 1993. 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 has been true not only for stocks but for bonds. 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 included 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.”

Two other papers provided valuable insights into the low-volatility anomaly. In his 2012 paper, “Enhancing a Low-Volatility Strategy is Particularly Helpful When Generic Low Volatility is Expensive,” Pim van Vliet found that while, on average, low-volatility strategies tended to have exposure to the value factor, that exposure was time varying. The low-volatility factor spent about 62% of the time in a value regime and 38% of the time in a growth regime. The regime-shifting behavior affected the performance of low-volatility strategies. When low-volatility stocks had value exposure, they outperformed the market by 2.0 percentage points on average. However, when low-volatility stocks had growth exposure, they underperformed by 1.4 percentage points, on average.

Luis Garcia-Feijóo, Lawrence Kochard, Rodney Sullivan and Peng Wang, authors of the 2015 study, “Low-Volatility Cycles: The Influence of Valuation and Momentum on Low-Volatility Portfolios,” found that there was no alpha in a four-factor model except in extremely cheap low-volatility environments.