In our previous post, we highlighted the “low-volatility effect” — the historical tendency for lower-volatility stocks to outperform higher-volatility issues. But IndexUniverse’s Elisabeth Kashner says the issue may be more complex than the simple notion that low volatility leads to better returns.

Recently, Kashner says, low-volatility strategies have lagged. Part of that is a result of sector allocations, but not all of it.  “Low-volatility investing became popular only recently, after investors saw the resilience of low-volatility strategies during the Great Recession,” she says. “Despite years of rising markets, investors have been seeking defensive strategies, and have been strangely rewarded by low vol in a market environment that ought to favor risk-taking. What’s going on?”

Kashner offers several theories. For one thing, she says, data on the performance of low-volatility strategies vs. the broader market are “quite sensitive to the time periods chosen”. She also says the “observer affects the observed” principle could be occurring. “Simply put, after the housing crash, playing defense is the new offense, and investors have been piling in.,” she writes. “Many portfolio managers have hopped on the defensive bandwagon, adding allocations to high-yielding dividend stocks and to low volatility. In the process, a strange thing has happened to low volatility valuations — they’re really not cheap anymore.” This could thus be a sign of a low-volatility bubble, she says, noting that academics have argued whether low-volatility outperformance is really due to volatility, or due simply to the fact that low-volitility stocks have historically tended to be cheaper.

Finally, Kashner shows that broader market volatility has been on the low side for the past year or so — and typically low-volatility strategies do better during times of market stress. The recent underperformance could thus just be what is “supposed” to happen, she says.