Low-Volatility Strategies Challenge Conventional Ideas of Risk and Return
If asked to sum up in a single word their investing experience over the last 15 years, many investors would likely say, “volatile.”
While the turn of the century brought with it an exciting outlook for technological and scientific advancement, it also seems to have marked the beginning of a new regime for investors. One decade into the new millennium, equity investors had endured not just one, but two sizable drawdowns:
Source: Bloomberg L.P., Sept. 30, 2013
In addition to the proliferation of 401(k) and online brokerage accounts, the increased availability of market commentary and data has contributed to a higher number of capital market participants, along with a heightened awareness of what markets are doing.
Combined, these trends have arguably made more investors more sensitive to market volatility, which in turn has generated growing demand for meaningful ways to address it.
Low-volatility strategies gain attention
One response to this demand has been the development of investment vehicles with the specific objective of offering equity exposure designed to be less volatile than the broader market.
Investors have increasingly adopted a “low-volatility” approach to investing in recent years. Research shows that while low-volatility stocks have historically often underperformed in up markets, they have tended to outperform in down markets, resulting in a smoother ride for investors. But the prospect of buffering the market’s dramatic ups and downs isn’t the only thing that’s drawn investors to low-volatility strategies — the well-documented benefits of low-volatility investing also include attractive returns relative to the broader market. As seen below, during the last 40 years, the highest-volatility quintile of US stocks underperformed the lowest-volatility quintile.
These returns run counter to conventional investing wisdom, which says that investors must take on more risk to achieve higher returns. In fact, the performance has caused enough head-scratching that researchers have coined the term “the low-volatility anomaly” to describe it.
One explanation, the so-called lottery effect, points to investors’ tendency to invest in high-volatility stocks in pursuit of a lottery-like payoff. The relatively high demand for such stocks pushes up their prices, which translates into a lower expected return.
Regardless of why the anomaly exists, the mechanics behind the outperformance should be intuitive to most investors — they are winning by losing less. Down-market performance is important because, as illustrated below, it’s much easier for investors to recover from smaller losses than it is from larger losses:
For illustrative purposes only.
To the extent that investors anticipate heightened volatility in the months and years to come, implementing a low-volatility approach may be a useful way of maintaining a desired level of equity exposure while potentially enduring fewer and smaller bumps in the road along the way.
Important information
There is no guarantee that low-volatility stocks will provide low volatility.
In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.
Underlying investments may appreciate or decrease significantly in value over short periods of time and cause share values to experience significant volatility over short periods of time.
Investments focused in a particular industry are subject to greater risk, and are more greatly impacted by market volatility, than more diversified investments.
The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.
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