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

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

Learn how to harness the low volatility anomaly2.

“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 anomaly2,” 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. Learn more about this factor with our Low Volatility 101 resource.

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 form 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 error 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.

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.

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.

Is there a pattern to factor performance?

Although factor performance isn’t guaranteed, different factors tend to outperform during different phases of the market cycle. The graph below shows which factors have the potential to perform better than the overall market as it rises and falls.

As you can see, the Low Volatility factor has historically outperformed during late expansion and early contraction — when the market is moving downward from a peak to a trough. Many observers feel that the market is currently in such a phase after so many years of a historic bull market. (To learn more, read "During Market Drops, the Low Volatility Factor Has Outperformed.")

Market cycle phases and factor performance behaviors chart
For illustrative purposes only. This should not be construed as investment advice nor as a recommendation of a particular strategy or product.

How can I implement the Low Volatility factor in a portfolio?

The Low Volatility factor exists in US and international stocks, and across the market-cap spectrum, so it can play a role across asset classes.

And, as the chart below shows, it has a particularly low historical correlation with the Value factor, and negative correlation with the Quality and Momentum factors. Therefore, it may potentially help to diversify portfolios that are concentrated in these areas.

During the past two years, many of the factors have had low or negative correlation to each other.
Source: Bloomberg L.P., as of June 30, 2019. Correlations below 0.50 represent increased diversification potential. Diversification does not guarantee a profit or eliminate the risk of loss. Low Volatility is represented by the S&P 500 Low Volatility Index; Dividend Yield by the S&P 500 Low Volatility High Dividend Index; Quality by the S&P 500 Quality Index; Value by the S&P 500 Enhanced Value Index; Momentum by the S&P 500 Momentum Index and Size by the S&P 500 Equal Weigh Index. An investment cannot be made directly into an index.

Is factor investing just a new fad?

No. The foundations for factor investing were laid in the 1960s, when the Capital Asset Pricing Model made a distinction between alpha as a measure of excess return over a benchmark, and beta as market risk. The first studies on the Low Volatility factor date back to 19753.

Are all Low Volatility factor strategies the same?

No, not all Low Volatility factor approaches are alike. For example – some have sector constraints, meaning that they must maintain at least some exposure to each sector at all times. So, if one sector is particularly volatile, that may result in a higher volatility stock being included in the portfolio over a lower volatility stock in a different sector.

Other strategies use a “pure” approach, meaning that the lowest volatility stocks are included in the portfolio, with no constraints. Such portfolios are generally rebalanced on a regular schedule (such as quarterly), to ensure that holdings can be adjusted as volatility changes.

Those who want full exposure to what the Low Volatility factor has to offer may want to consider a pure approach. Such an approach may help investors avoid major sector downturns and bubbles. During the technology bubble of 2000 and the financial crisis of 2008, a sector-constrained portfolio could have resulted in extended exposure to out-of-favor sectors.

Learn more about the “pure” approach of Invesco’s Low Volatility suite of products.

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.

3 Risk and the Rate of Return on Financial Assets: Some Old Wine in New Bottles, Robert A Haugen and James Heins, The Journal of Financial and Quantitative, Analysis, December 1975.

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