Once a month in our Equity Observer publication we share our analysis of what stock selection factors are working. This year the best performing factor in our global sample is “low volatility”.
The issue of what constitutes a factor will be endlessly debated, but while “low vol” does not quite rank up there among academics with the original Fama-French-Carhart variables (market, size, value, momentum) there is nevertheless a growing investor demand for lower volatility strategies.
The growing demand for “low vol” strategies does not seem entirely driven by the performance of these strategies relative to core benchmarks. For example over the 2015-2013 period the S&P Low Volatility Index under-performed the S&P 500 core index by 3.4% annualized. Yet demand for these strategies appears to have grown as manifested by the large number of new ETF’s launches in this space.
Investors seem particularly interested in the capital preservation characteristics of “low vol” strategies and appear willing to sacrifice returns during the good times in return for less pronounced equity market downdrafts.
Low volatility strategies seem here to stay. Given their market beating returns thus far in 2016 it is reasonable to expect growing interest. We therefore analyze our global sample of 13,000 stocks to ascertain the basic characteristics of low volatility stocks.
Stocks in the lowest volatility decile have an average return volatility of 20%
Higher volatility stocks exhibit low levels of market sensitivity (beta)
During periods of equity market stress ‘low vol” strategies should out-perform broad market indices
The lowest volatility decile enjoys the highest current yields while the “high vol” names in Decile 10 barely register for income
Lower volatility stocks have lost their historical valuation advantages. The growing demand for ‘low vol” and its close cousin dividend income have eroded the typically lower valuations seen in lower volatility sectors and stocks.
Even after adjusting for sector and region/country effects we observe a strong monotonic relationship in YTD returns across volatility deciles.
The lowest volatility stocks (Decile 1) have had the highest 2016 returns while the highest volatility stocks have shown the greatest losses.
Our general conclusion is that “low volatility” strategies play a useful role for investors looking to provide short-term downward protection in their equity portfolios. However, we think of “low vol” as part of a package of stock attributes designed to lessen market exposure during periods of equity market stress. These strategies along with lower betas, higher yields and exposure to more stable sectors should exhibit lower levels of downside capture.
Investors worried about equity market downturns should not view these strategies as a substitute for properly assessing and managing the risk of their overall portfolios.
Click here to download the report: Low Volatility – One Factor or Several?
Eric J. Weigel
Managing Partner and Founder of Global Focus Capital LLC