The Dark Side of Low-Volatility Stocks

Long Bonds?

October 2018. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Low-volatility stocks have outperformed the market over the last 25 years
  • The strategy has reduced equity drawdowns in the US, Europe, and Japan significantly
  • However, low-volatility stocks have partially been bond-proxies, which poses risk when rates rise

MARKETING INGENUITY IN FINANCE

Smart beta may be the best marketing concept ever invented in finance. Buying something labeled “smart beta” makes you intuitively feel both smart and good about the investment. But if smart beta is the best investment product label ever, low volatility is a strong contender for second place. It isn’t hard to see why.

After the global financial crisis, risk was front of mind for investors, so buying stocks with lower volatility, perhaps even bond-like characteristics, had obvious appeal. Since then, low-volatility strategies have rapidly gathered assets and today low-volatility exchange-traded funds (ETFs) in the United States account for about $46 billion in assets under management (AUM) (read Low Volatility, Low Beta & Low Correlation).

But the strategy isn’t immune to criticism. Some contend the underlying stocks are effectively bond proxies that have benefited from the declining interest rates over the last few decades. So just how does this low-volatility strategy perform across markets? And does it really suffer from interest-rate exposure as its critics claim?

LOW-VOLATILITY STRATEGIES IN THE UNITED STATES

To answer these questions, we created a long-only portfolio composed of the top 10% of US equities ranked by price volatility over the last 12 months with monthly rebalancing. We then compared it to the US stock market. We found that the low-volatility portfolio outperformed the stock market since 1991. While there was a period of slight underperformance during the tech bubble, the portfolio outpaced the stock market during both the subsequent crash and the global financial crisis from 2007 to 2009. These initial results make a strong case for low-volatility stocks.