We have written that volatility is part of every investor’s journey and long-term investors with diversified portfolios should see volatility as a normal part of investing. There are many ways to improve portfolio construction and one method that has gained academic and practitioner support targets low volatility equities. What does this mean?
An equity is considered low volatility if its price tends to move around less than other equities. The concept is pretty simple. An index provider uses a filter to select a range of equities empirically shown to have lower volatility compared with other stocks in the broad market. For example, the provider could take the S&P 500 index (the largest 500 stocks in the United States) and make an index of a subset of 100 of them, picking the ones with the lowest level of volatility.
Is low volatility contrary to Modern Portfolio Theory?
A classic theory in investments since the middle of the last century, Modern Portfolio Theory fathered by Harry Markovitz and William Sharpe among others, says that for a diversified portfolio, return is linked to risk or volatility. The more risk you take, the more you should be compensated over the long run.
In reality, things aren’t always as clear as the theory. Low volatility investing appears to be something of an anomaly. It has been extensively studied in the academic literature1 and studies have usually agreed with the conclusion that stocks with low volatility on average outperform or perform at least in line with the rest of the market, with a better risk-adjusted return (in essence with less drawdowns and volatility).
The jury is still out on why low volatility equities outperform
One theory presented to explain this phenomenon is the idea that stocks with high volatility tend to represent a subset of more unstable companies whose earnings vary. A lot of stocks with hype around them (we could mention WeWork or Uber lately) have often been difficult to value. Investors can easily be overexcited about their prospects, leading to a large increase followed by losses in their share value.
On the contrary, companies with stable businesses, regular cashflows and dividends offer less room for variation in their valuation, resulting in a more stable price profile and usually lower volatility. These companies can often be seen as boring and not offering the hope of substantial gains, but they have been shown to regularly outperform in the long run, or at least to generate comparable returns to other equities, with the benefit of much lower volatility and drawdowns.
To illustrate this, the charts below highlight the performance of the MSCI US Index and the MSCI US Minimum Volatility Index during market drawdowns since 2005.
The charts shows that significant volatility still exists, but the stock screening underlying the approach succeeds in softening drawdown episodes.
Source: Macrobond, Factset, Nutmeg
So, should I put all my money on low volatility stocks?
Of course, Nutmeg would recommend investors use a greater level of diversification than just low volatility equities. While these indices have shown compelling risk/reward characteristics over time, they have been prone to periods of underperformance – in particular, during stock market rallies and when bonds underperform. It is important to invest in low volatility equities selectively during periods when they offer real risk/reward potential for portfolios rather than using them permanently.
How Nutmeg invests in low volatility equities
At Nutmeg, we tend to use low volatility equities defensively. At present, these equities are part of our portfolios because we have become more concerned about US-China trade uncertainty during the course of 2019. We currently invest in two low volatility exchange-traded funds (ETFs), the iShares MSCI EM Minimum Volatility and the iShares S&P 500 Minimum Volatility. Our overall position in low volatility ETFs remains modest and one reason for being cautious is that low volatility stocks are currently expensive compared with other stocks. We are permanently assessing the risk/reward of each investment among our managed portfolios including the low volatility suite of ETFs and stand ready to update our allocation to best serve our clients’ long-term investment objectives.
- The Volatility Effect: Lower Risk Without Lower Return; Journal of Portfolio Management 2007; David Blitz & Pim van Vliet, Robecco AM
- The Low-Volatility Anomaly: Market Evidence on Systemic Risk vs. Mispricing; AQR team Research Paper 2016; Xi Li, Rodney N. Sullivan, Luis Garcia-Feijóo
As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past performance is not a reliable indicator of future performance.