Some people live on adrenaline and adore risk, while some prefer low key longevity. If being dull can deliver solid returns, would you mind being called a bore?
Factor investing has gained much popularity in the last few years. In essence, factors are attributes that are likely to influence investment returns; for example, the growth factor may generate higher but riskier returns, while the quality factor may generate more stable returns, but you won’t win big.
A factor that we like at The Index Standard is “low volatility”. Low volatility (or low risk) is expressed by purchasing assets with the least movement (or the least volatility) over a set period or optimizing a basket of assets designed to produce the lowest movement. We like its ability to reduce drawdowns and provide stable returns1, to which more later. But investors should be mindful of the methodology of their chosen low volatility indices, which can deliver different outcomes.
Low Key, But More Reliable
That’s how researchers would describe the low volatility factor. Stocks with low volatility characteristics tend to be less sensitive to sharp market ups or downs. They are not drama queens like the high beta stocks - some might even say they are boring. But while the price of high beta stocks can surge, they can also fall back hard and sometimes after big plunges and it can be awfully hard to climb back to where it was.
The low volatility factor is interesting because it defies a core tenant of investing that higher risk should generate higher returns. How, you ask, does lower risk outperform the market?
First, many institutional investors are constrained from using leverage. As a result, they often pick high beta stocks to try to outpace the market. However, this preference can lead to stretched valuations and lower returns in the long run.
Second, there is the so called “lottery effect”, in which investors intentionally pick riskier stocks such as tech startups in their quest for higher returns. The lottery effect is an example of the return-chasing behavior of investors who want sizeable returns. The irony is, when the demand for a stock goes up, it drives the price up, stretches valuations and makes the stock less likely to outperform the market in the long run. Meanwhile, some stocks perceived as safe and boring are not in as much demand and are underpriced by comparison, giving them a better chance to outperform the market.
How Is Low Volatility Measured?
Low volatility metrics tend to select assets with the lowest volatility in a preceding period, usually 12 months. In addition, the factor can be expressed as minimum volatility. This process seeks to minimize the volatility of a portfolio and typically relies on optimizers to select the underlying assets and their weights. In fixed income, low risk via credit rating and short maturities are the typical metrics.
At The Index Standard we caution that these two metrics, when used on stocks, can lead to a variety of investment outcomes. One flaw to be aware of is that some methodologies can overweight certain sectors with low volatility characteristics, in which case a sector cap will help reduce the risk. See our index ratings for further insights.
Visit The Index Standard library for information on other popular investment factors.
- “The Cross?Section of Volatility and Expected Returns” Andrew Ang, Columbia Business School, Robert Hodrick, Columbia Business School Yuhang Xing, Rice university and Xiaoyang Zhang, Cornell University, Journal of Finance, July 2003.