Consider Low Volatility ETFs

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What is the Low Volatility Factor and Why Does it Matter?

Learn how to harness the low volatility anomaly.2

“More risk equals more return” – this is a common misperception among investors. While highly volatile stocks may indeed deliver bursts of impressive performance, academic research1 has found that lower-volatility stocks have historically generated better risk-adjusted returns over time. This is known as the “low volatility anomaly,2” and it’s the reason why many long-term investors have included Low Volatility factor strategies in their portfolios.

What is the Low Volatility factor?

Factors are measurable characteristics of a security that help explain its performance. The Low Volatility factor applies to the stocks that have been the least volatile in their asset class over time — avoiding the sharper ups and downs of other stocks.

Why does it exist?

There are several reasons why the Low Volatility factor has the potential to outperform the broad market over the long term:

  • The “lottery effect.” Investors can treat stocks like a lottery ticket, seeking larger returns by buying relatively riskier stocks. This "lottery effect" bids up the price of riskier stocks and results in lower risk, out-of-favor stocks being systematically underpriced, which may translate into outperformance.
  • Leverage aversion. In finance theory, due to the efficient market hypothesis, investors are taught that the only way to earn a return above the market is via leverage (borrowing to buy more of the market portfolio). However, many investors are restricted from using leverage in their portfolio. As a result, to earn added risk, they buy riskier or higher risk stocks, which leads to the type of lottery effect described above.
  • Limits to arbitrage. In many cases, institutional investors are judged by their performance to a fixed benchmark. As a result, their equity portfolios are constructed to match the sector exposures within a benchmark index such as the S&P 500 or Russell 1000. But pure low volatility strategies are built from the bottom up, and the lowest volatility stocks are included no matter which sector they’re in. As a result, low volatility strategies can possess large tracking errors or materially deviate in their sector exposures relative to the benchmark. For this reason, the benefits of the low volatility anomaly are not priced or arbitraged away and are allowed to exist in the marketplace. Institutional investors have little incentive to arbitrage the anomaly away.
Why does low volatility matter?

Simple math tells us that the more a stock’s price falls, the more it has to gain just to get back to even.

  • If a stock loses 10%, it has to gain 11.1% to get back to even.
  • If a stock loses 25%, it has to gain 33% to get back to even.
  • If a stock loses 50%, it has to gain 100% to get back to even.
  • If a stock loses 80%, it has to gain 500% to get back to even.

While volatility can fuel spikes in a stock’s price, it can result in plunges as well. Over the long term, it can be harder for a high volatility stock to make back what it’s lost.

Important Information

  • 1 Benchmarks as Limits to Arbitrage: Understanding the Low Volatility Anomaly, Malcolm Baker, Brendan Bradley and Jeffrey Wurgler, Financial Analysts Journal, January/February 2011.
  • 2 A common assumption in finance is that increasing a portfolio’s risk exposure should generate a higher return. In contrast, the low volatility anomaly refers to the observation that historically, portfolios of lower-volatility stocks produced higher risk-adjusted returns than portfolios with high-volatility stocks.
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