The low-volatility factor was first documented in the early 1970s by US academics Marshall Blume and Irwin Friend.
Although highly volatile stocks can produce impressive bursts of performance, Blume and Friend showed that stocks that are less volatile have historically generated better risk-adjusted returns.
From a risk perspective, the low-volatility factor is rather puzzling. In theory, higher expected return compensates for higher expected risk, not the other way around. So, how can the low-vol premium be explained?
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Transcript:
Some stocks are more volatile than others.
Although highly volatile stocks can produce impressive bursts of performance, the evidence tells us that stocks that are less volatile have historically generated better risk-adjusted returns.
The low volatility factor was first documented in the early 1970s by US academics Marshall Blume and Irwin Friend.
Although Gene Fama and Ken French didn’t include low volatility in their updated five-factor model in 2013, they did acknowledge that it exists.
The low vol premium, they argued in a separate study two years later, is connected to the two new factors they did include — profitability and investment.
“Returns of low volatility stocks,” they wrote, “behave like those of firms that are profitable but conservative in terms of investment, whereas the returns of high volatility stocks behave like those of firms that are relatively unprofitable but nevertheless invest aggressively.”
Positive exposure to the profitability and investment factors, they went on, goes a long way toward capturing the average returns of low-volatility stocks.
From a risk perspective, the low-volatility factor is rather puzzling. In theory, higher expected return compensates for higher expected risk, not the other way around. So, how can the low-vol premium be explained?
One explanation is the so-called “lottery effect”. Investors in search of larger returns sometimes treat highly volatile stocks like a lottery ticket.
This bids up the price of riskier stocks. As a result, lower risk stocks are systematically underpriced, which may translate into outperformance.
So let’s take a look at how the the low-vol factor has performed.
In the US, between 1963 and 2016, the lowest risk stocks produced an annual return of 10.9% compared to 4.1% for the highest risk stocks.
In the UK, between 1984 and 2016, the lowest risk stocks produced an annual return of 11.6% compared to 4.2% for the highest risk stocks.
What about more recent history? Well, in the five-year period to the end of April 2021, the MSCI ACWI Minimum Volatility Index returned 10.57%, while the parent index returned 14.54%. In other words, there was a negative low-vol premium.
True, a tilt towards low volatility would have softened the drawdown we saw in March 2020. But high-volatility stocks performed better than low-volatility stocks in the subsequent recovery.
How, then, does the MSCI ACWI Minimum Volatility Index differ from the parent index?
For a start, the turnover is much higher — 21% versus 4% for the year to end the end of April 2021.
The Min Vol Index has a negative exposure to momentum stocks.
And if you look at the top ten constituents of each index, you’ll see there are no stocks in both.
There are no big names in the Min Vol Index — no Tesla, Microsoft, or any of the FAANG stocks, for example.
So let’s take the third top constituent on the list — Waste Management.
The stock makes makes up 1.33% of the Min Vol index, but has a weighting of just 0.09% in the parent index.
What, then, are the advantages of tilting a portfolio towards low-risk stocks?
Effectively, they have a double benefit.
One the one hand, as we’ve explained, lower volatility stocks have historically produced higher returns than the broader market in the long term.
On the other hand, because they’re lower risk, they reduced the overall risk of the portfolio.
Low volatility can also be blended with other risk factors to maximise the expected return.
As with all the different risk factors, it’s extremely hard to predict when is a good time or a bad time to be exposed to low volatility. But a steady exposure over the long term should prove beneficial.