Don't Overreact

Taking a low volatility approach to uncertain markets

The recent shock to economic activity created by the spread of COVID-19, flaring tensions between Turkey and Syria in the Middle East, and the upcoming US presidential election are a reminder that equity prices can be volatile, and risk is ever present.   In fact, the CBOE Volatility Index (VIX)¹, a measure of expected equity volatility for the S&P 500 Index, finished the week ending February 28, 2020 at 40.11%. That high a level of volatility has not been seen since the summer of 2015, when Chinese stocks fell 40% and the Chinese yuan was devalued because of concerns about poor economic growth².  A VIX close over 40 is unusual and has occurred in only seven periods since 1990, but it does happen.  Timing and trading the impact of black swan events and geopolitical uncertainty are difficult endeavors for even the most seasoned financial professionals.  Investors looking to navigate a world of risk and manage the ups and downs of equity investing may want to consider a low volatility strategy.

What’s a low volatility strategy?

As the name implies, low volatility strategies focus on stocks with a history of lower volatility than their peers. For example, the S&P 500 Low Volatility Index³ invests in the 100 stocks out of the S&P 500 Index that had the lowest realized volatility over the past 12 months.

We see two main benefits to this approach:

• Upside participation. Because they invest in stocks, low volatility strategies have the potential to rise along with the equity markets (though they tend not to gain as much as higher volatility stocks). For example, between April 30, 2011, and August 31, 2019, the S&P 500 Low Volatility Index captured 76% of the upside of the S&P 500 Index.⁴
• Downside risk mitigation. At the same time, low volatility strategies have tended to lose less when equity markets fall. From April 30, 2011, to August 31, 2019, the S&P 500 Low Volatility Index captured just 42% of the downside of the S&P 500 Index^.4

It’s this second feature that may be particularly attractive after the type of volatility we’ve seen this year. Below, we illustrate how a low volatility approach has outperformed during significant downturns in the large-cap, mid-cap, and small-cap markets. During particularly weak equity markets (as defined by a 5% drop or greater in the benchmark indexes for each cap size), the low volatility indexes have averaged excess returns of 4.29%, 2.98%, and 2.71% over the large-cap, mid-cap, and small-cap benchmarks, respectively.