By Jack Forehand, CFA (@practicalquant) —
Like many investors, I like to follow strategies that make sense to me. If I am following a factor, I want to feel like the metrics used by that factor are tied to the underlying business I am investing in and its future success. That is one of the reasons I tend to be attracted to value. I have a belief that if I pay less for a dollar of earnings or cash flow, I should earn an above average return for doing it. The reality is obviously much more complicated than that, but value is a strategy that it is easy for all of us to intuitively understand.
That desire to invest in strategies that are easy to understand can be a doubled-edged sword, though, because it can lead me away from factors like momentum that are supported by equally strong evidence. Even after using momentum for a very long time and understanding the compelling evidence that it works, I still struggle in my own mind to buy stocks for no reason other than the fact that they have gone up.
As much as I still struggle with momentum, I struggle even more with low volatility. In a world that makes sense, to get a higher return, I should have to take on additional risk. And if I reduce my risk, I should lose some return as a result. But low volatility seems to fly in the face of that. Depending on the data you look at, low volatility stocks either produce a similar return to the market with less risk or might even produce an excess return.
Given my own reservations about low volatility and the fact that I haven’t written about it before, I thought this would be a good opportunity to take a look at the factor and some of the key lessons that I think investors should know about it.
Why Does Low Volatility Work?
Factors typically work for two different reasons: either they produce an excess return by taking on more risk or they capitalize on the behavior of other investors that leads to a mispricing. With low volatility, using the risk-based framework doesn’t lead to very satisfying results since by definition the factor is selecting lower risk stocks. Low volatility is certainly prone to periods of underperformance just like the other factors (as anyone who has invested using the factor since the market bottom last year will tell you), but using a standard risk framework, it is difficult to explain why the factor works.
That leaves us with the behavioral based explanation. But that can be challenging with low volatility as well. With value and momentum, the behavioral explanations are more intuitive, but in this case you have to dig a little bit deeper to come up with one. The best explanation I have heard is that investors who cannot use leverage need a mechanism to boost their returns. As a result, they seek out higher volatility stocks as a means to do that and thus create a situation where they are overpriced relative to their low volatility counterparts. This creates a relative opportunity.
Low Volatility and Other Factors
For investors like me who tend to be on the skeptical side when it comes to the factor, the good news is that it doesn’t need to be used on its own to be effective. In fact, research has shown that using low volatility with other factors enhances its long-term return without a major impact on its risk reducing benefits.
Pim van Vliet of Robeco Asset Management has done the best work I have seen on this and he has found that both value and momentum can enhance a low volatility strategy. In his paper “Enhancing a low-volatility strategy is particularly helpful when generic low volatility is expensive”, he found that when low volatility is cheap, it outperforms the market by 2.2% per year, but when it is expensive, it underperforms by 1.4% (although it still outperformed on a risk-adjusted basis). In his paper “The Conservative Formula: Quantitative Investing made Easy”, he also found that coupling low volatility with price momentum and high net payout yields produces enhanced returns. The formula produced a 15.1% annualized return since 1929, which was well in excess of the market return.
Low Volatility is a Chameleon (Sort Of)
I wrote an article a few weeks ago where I looked at the changing nature of momentum. My point in the article was that momentum will exhibit major changes over time with respect to both its sector exposures and its exposures to other factors. Low volatility also has the ability to do that too, but in practice it is a chameleon that does a lot less changing.
While the sector exposures of low volatility can vary, they are fairly consistent over time. As a simple example, here are the sector over and underweights of the top decile of stocks using our low volatility ranking relative to our equal weight universe as of today compared to what they were at the market bottom last March.
A lot has changed in the market since then, but not much has changed with low volatility.
The factor exposures over the same period do show some more significant movement, though. Here is a look at what the top decile of low volatility stocks in our database looked like using our factor scores at the market bottom in March 2020 vs. what it looks like today (scores range from 1 to 99 and higher scores indicate more exposure to the factor).
The data essentially shows what you would expect with low volatility struggling relative to the market over the period. It has gotten significantly cheaper, but has lost a lot of momentum. What is interesting is that its exposure to quality has risen. Going back to the research I referenced earlier that low volatility works best when it is coupled with value, the factor in many ways looks much more attractive now than it did a year ago.
The Factor That Shouldn’t Work
There are many skeptics about low volatility because the logic behind it seems to challenge the core investing belief that increasing returns should require taking on more risk. I can understand these arguments because I am one of these skeptics myself. But in the end, there is strong evidence to support the factor. The evidence may not rise to the level of the evidence supporting value or momentum, but it is still hard to refute. Even if the risk of low volatility doesn’t show up in standard risk metrics, though, it still exists. The past year is a good example of that. But for investors who want to focus on reducing volatility in their portfolio, the factor is certainly worthy of consideration.
Jack Forehand is Co-Founder and President at Validea Capital. He is also a partner at Validea.com and co-authored “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Jack holds the Chartered Financial Analyst designation from the CFA Institute. Follow him on Twitter at @practicalquant.