What if you told somebody that stocks with lower risk earn a higher return? They may look at you and call you crazy, unless they’re familiar with the “Low Volatility” or “Defensive” factor, which has been very well documented in academic asset pricing literature. Indeed, this absolute paradox exists, that stocks which exhibit low volatility or a low beta to the market, outperform stocks which exhibit high volatility or a high beta in the long run – which yes, entirely defies the logic of the Capital Asset Pricing Model (CAPM), which predicts a positive relationship between risk and return.
If you’re thinking this sounds too good to be true, well, you’re right. Based on “traditional” measures of risk such as volatility and beta, you are getting higher risk-adjusted return, however – the low volatility strategy comes with its own, more niche risks. Before delving into the risks, low volatility strategies were the most resilient throughout the below 6 recessions/drawdowns on average:
Source: Research Affiliates[1]
Whilst this is great and makes a very solid case for low volatility going into a recession, today’s situation is not whether there will be a recession, but when. To note, low volatility strategies tend to be biased to more “defensive” sectors such as utilities and consumer staples, though the “defensiveness” of a particular sector may change over time depending on secular trends and disruptive innovation (e.g., software in technology).
Reasons for why Low Volatility works.
Many have tried to explain the intuition of this anomaly through a behavioural lens, and unconventional risk-based lenses, which is inherently difficult given a lot of empirical finance is built upon the original building blocks of CAPM theory.
- One key factor is leverage constraints, as we operate in a world where investors, institutions, and financial regulators strictly limit leverage. An unconstrained investor can simply leverage up a low-volatility strategy, enhancing return potential without incurring additional risk. Alternatively, high-beta stocks offer a route to enhancing returns without resorting to margin trading or leverage. Higher beta stocks are therefore flocked into, to try and boost their returns, overpricing the high beta stocks and under-pricing the low volatility stocks, even though they’re less risky.
- During “bad times”, liquidity constrained investors must sell these leveraged positions in low-risk stocks, further increasing expected returns.
- Another take is that Low volatility strategies have quite a high “tracking error” (the difference in the performance between of an investment and its benchmark), which may not fit with very large institutional passive mandates, leaving a premium on the table.
- To note, this high tracking-error primarily appears during drawdowns, which is actually “good” tracking error, despite the contradiction of it being described as an “error.”
Source: Bloomberg, Innova Asset Management
- The third reason is that investors are biased towards higher-risk stocks in search of higher returns, and tend to overpay for them, leaving low-risk stocks to yield a premium. Empirical evidence highlights the disproportional allocations to high-beta stocks within managed funds – in general, we see these high-risk stocks among news headlines a lot more commonly than “boring” low-risk stocks in sectors such as utilities and consumer staples.
Long-only practical portfolio perspective
Note: Inception since 05/1988
We’ve used long-only smart beta indices to try and make this as applicable for multi-asset portfolios as possible. As seen above, in a long-only context, since inception (05/1988), the MSCI Minimum Volatility index has been a strong performer on a risk-adjusted basis alongside the broader MSCI World index and the MSCI World Value index.
Source: Bloomberg, Innova Asset Management
A common belief in the Innova playbook is the importance of the price you pay for a particular asset. This same belief translates to factor premia too, where when a particular factor is “overcrowded”, or in our lingo overvalued, it may not produce glamorous expected returns over a shorter period. This phenomenon is important within the low volatility factor, where some studies have shown that 60-70% of the premium has been delivered when the factor was cheap.
Source: Morningstar, Innova Asset Management
As seen the MSCI minimum volatility trades around fair value compared to its 13-year average based on P/E, P/B, P/S and P/CF. It may be wise to combine low volatility with factors such as value to control for the valuation, or controlling for momentum, to avoid buying low volatility stocks with exposure to uncompensated factors (such as low momentum or growth stocks).
Source: Morningstar, Innova Asset Management
Above displays the valuation spread of smart beta ETFs against the broader MSCI World, which is an indicator often used to understand the relative valuation of a particular factor. Clearly, “Min Vol” has become cheaper relative to the broader market recently, with small caps looking the cheapest – but at this point everyone knows that!
Sector composition
The sector composition of low volatility strategies (in this case the S&P 500 Low Volatility index) takes swings over time and is quite different to a regular broad-based index:
Source: S&P Dow Jones Indices LLC.
Clearly, low volatility strategies are biased towards consumer staples, utilities, sometimes healthcare and financials. These are typically “defensive” sectors, and as mentioned before, since 2016 we could see an uptick in IT as it starts to act more “defensive” due to innovation and software dependencies.
Elephant in the room – the COVID drawdown
A lot of criticism for the low volatility factor came around the COVID crash, where depending on how the strategy was specifically invested, drew down similar to the market. Low volatility was supposed to mitigate greatly on the downside – but not reach 100% on the upside:
Source: Bloomberg, Innova Asset Management
This caused a lot of investors to lose their belief in the factor, however when actually digging into the crash – it wasn’t really the factor’s fault… Given we had a “pandemic” recession, all tangible, services related sectors such as retail (consumer), restaurants and other “staples’y”, “real-life” stocks were especially hurt. These types of stocks are especially prevalent within low volatility strategies, but many just said the factor was “dead” and moved on, which ironically leaves more premium on the table for investors who are appropriately able to attribute the losses during this time.
So, should you invest in low volatility strategies?
Low volatility strategies certainly have proven to be a protector of capital in most recessions, and with a potential drawdown looming, it may be appropriate to have defensive sectors in the portfolio, especially with valuations being around fair value.
The low volatility factor diversifies drivers of risk and can yield premium in the long run as demonstrated by academics, as long as the investor is able to bear high tracking error and deviations from benchmark portfolios. Controlling for value is important within low volatility strategies, but particularly, ensuring that it fits with the other return drivers in the portfolio is also very important, ensuring that it doesn’t cancel out any other factor exposures that you may have, and avoiding any unintended risk bets.
[1] https://www.researchaffiliates.com/publications/articles/808-value-in-recessions-and-recoveries
Quarterly market update | Q2 2024