Low Volatility Can Spell High Returns

Equity investors have long sought to exploit two well-known market anomalies —the long-run outperformance of small-caps and of stocks with low valuations. Asset managers offer an array of services to capture these well-established effects.

Less well known, and less targeted by the industry, is a third major exception to efficient market theory: that less-volatile stocks typically outperform over the long term. This low volatility effect has been demonstrated in academic research since the 1970s, but until recently few products have been available to capture it.

On the face of it, the clear evidence that stocks with less price volatility also provide better returns is surprising: shouldn’t investors have to accept lower returns in order to experience less risk? In fact there are a number of aspects of investor behaviour that may explain the outperformance of low volatility stocks.

For example, overconfident investors often overpay for perceived “winners”, many of which end up disappointing. Asset managers, especially if incentivized by performance fees, may focus on high beta stocks in the hope of boosting outperformance in up markets. And the typical institutional investor practice of measuring performance relative to a benchmark discourages managers from building the very unbenchmark-like portfolios that are needed to capture the low volatility effect.

So how can the benefits of low volatility be captured in real portfolios? Stocks which have been less volatile in the past tend also to be less volatile in future, making likely candidates for a low volatility portfolio relatively easy to identify. By selecting stocks which also score highly on quality, in areas like profitability and good balance sheet management, our research suggests that it is possible to add extra return without adding risk. And fundamental company research can help weed out companies whose past stability may be under threat.

Of course, low volatility portfolios won’t outperform all the time. Not surprisingly, our research shows that they tend to lag in strong bull markets. But the downside protection they provide in bear markets should more than offset this (Download the pdf from the right side bar to view the display).

Historical simulations need to be treated with caution. Even so, our research makes us very confident that the low volatility approach can give investors access to the long-term returns provided by equities, but with less pain in down markets than many have recently experienced.