Understanding Low Volatility Investing

Understanding Low Volatility Investing

What is Low Volatility Investing?

Low volatility investing is an investment approach that focuses on stocks with low price fluctuations. The core tenet is that lower risk stocks, as measured by volatility of returns, can generate better risk-adjusted returns over the long run compared to the overall market. This runs counter to standard financial theory which states that investors must take on more risk to achieve higher returns.

Why Does Low Volatility Investing Work?

There are several behavioral and structural reasons why low volatility stocks may outperform:

  • Many investors have a “lottery mentality” and irrationally overvalue high risk stocks while undervaluing lower risk stocks. This can lead to lower risk stocks becoming underpriced.
  • Institutional investors often have a mandate to beat a benchmark index. This can cause them to favor higher beta, more volatile stocks.
  • Leverage constraints can also force investors to prefer higher volatility stocks. Borrowing restrictions mean investors use volatility as a proxy for risk.

Measuring Low Volatility

Low volatility can be measured in different ways but standard deviation of returns is one of the most common. Standard deviation measures the dispersion of returns over a given period. Stocks with a lower standard deviation experience smaller price fluctuations and are considered less volatile. Other potential measures of volatility include beta and downside standard deviation.

Academic Research

Extensive research has shown the low volatility anomaly to be a persistent market phenomenon. In the paper “Benchmarks as Limits to Arbitrage: Understanding the Low-Volatility Anomaly” Baker, Bradley, and Wurgler found that U.S. stocks with the lowest volatility significantly outperformed from 1968-2008.

Pim van Vliet, author of the book High Returns from Low Risk, has also conducted and compiled considerable research on low volatility investing. Along with David Blitz, his 2007 study “The Volatility Effect” documented the low volatility effect across global markets. Van Vliet also found that combining a low volatility approach with other factors like momentum and net payout yield can further enhance risk-adjusted returns.

Validea’s Low Volatility Model

Validea’s model based on Pim van Vliet starts with the 1000 largest stocks in the U.S. and eliminates the 500 with the highest standard deviation. The remaining stocks are then ranked based on momentum and shareholder yield (dividends + buybacks). This quantitative approach implements van Vliet’s research findings that combining low volatility with other factors that have worked well historically can lead to market-beating returns.

5 Stocks Scoring Well

The following five stocks currently score highly based on Validea’s models and also exhibit low volatility based on standard deviation:

  1. McKesson Corp (MCK) – McKesson is one of the largest global pharmaceutical distributors. It scores a perfect 100% on Validea’s Pim van Vliet low volatility model due in part to its low 21.5% standard deviation of returns and high shareholder yield of 8.5%. It also scores well on the Patrick O’Shaughnessy and Meb Faber multi-factor models.
  2. Check Point Software Technologies (CHKP) – Check Point provides cybersecurity solutions to enterprises, government and small businesses. With a 22.4% standard deviation over the past 3 years, it has exhibited low volatility. It scores 93% on the van Vliet model and also gets high scores from our model based on Patrick O’Shaughnessy.
  3. Carlisle Companies (CSL) – Carlisle is a diversified manufacturing company that produces commercial roofing and other engineered products. Its 28.7% trailing 3-year standard deviation is well below the market median. CSL scores a 100% on both the van Vliet low volatility model and the Twin Momentum model based on Dashan Huang’s research.
  4. Cardinal Health (CAH) – Cardinal Health is a distributor of pharmaceuticals and provider of services to healthcare providers. With a 24.9% standard deviation, it lands in the lowest volatility half of stocks in Validea’s database. CAH gets a 100% score on the van Vliet model and also registers high scores on the Patrick O’Shaughnessy Millenial and Meb Faber Shareholder Yield models.
  5. Hartford Financial Services Group (HIG) – Hartford Financial provides insurance and financial services. The company’s 22.5% trailing 3-year standard deviation makes it a low volatility stock. It scores a perfect 100% on the Pim van Vliet model and also gets high marks from the Peter Lynch P/E Growth model and Dashan Huang Twin Momentum model.

Low volatility investing is a compelling approach supported by historical data and academic research. By focusing on stocks with smaller price fluctuations and combining that with other alpha-generating factors, investors can aim to achieve superior risk-adjusted returns. The five stocks highlighted score well across multiple models used by Validea while also exhibiting low standard deviation compared to the overall market.

Research Links

Low Volatility Stocks

Validea’s Pim van Vliet Based Model