Musings on Low Volatility

Has minimum volatility minimized volatility in 2020?

June 2020. Reading Time: 10 Minutes. Author: Rodolfo Martell.

SUMMARY

  • The Low Volatility strategy failed to protect investors in March and April 2020
  • Industrials & materials generated positive and technology & real estate negative relative performance
  • Low Vol strategies do not deliver ESG benefits

INTRODUCTION

Low volatility (Low Vol) strategies have gained popularity over the past decade with retail and institutional investors alike. Although initially, their adoption was slow (does Low Vol have a rational risk-based explanation? A behavioral one? Does it arise from structural inefficiencies?), as their successful track record built up, assets started piling in. Even when in recent years evidence showed Low Vol strategies getting progressively more expensive, investors continued to allocate money to them given their positive performance (read Low Vol Factor: From Obscurity to Stardom).

One big misconception remains regarding Low Vol strategies: it is still often thought of as a passive strategy, partly because a Low Vol strategy typically tracks a low volatility or minimum volatility index. Let us be clear about one point here: Low Vol is an active strategy, and its positions should be measured against a regular cap-weighted benchmark.

So, to evaluate Low Vol strategies we have to look at the improvements in risk measures like volatility, drawdown profile, beta reduction versus a market capitalization-weighted benchmark, and Sharpe ratio improvements, among others, which we will evaluate in this short research note.

LOW VOLATILITY PERFORMANCE IN 2020

Low Vol strategies, as measured by the largest ETF namely USMV in this smart beta category, started the year continuing the positive trend from previous years, outperforming a regular capitalization-weighted benchmark such as the S&P 500. By mid-February, Low Vol reached its 2020 peak at 6.2%, compared to 4.9% for the regular cap-weighted benchmark.

Then, while the COVID drawdown unfolded, Low Vol continued to minimally outperform, beating the benchmark by only 2.7% by the end of March. Since then, as the chart below shows, both strategies have posted a swift recovery, with a neck-to-neck photo