Do Low-Volatility Strategies Produce High Returns?
What are low volatility strategies? Low volatility strategies attempt to construct equity portfolios that minimize market risk. Investment risk is measured using historical returns and correlations between individual portfolios and stock market movements. Wall Street touts low volatility investment strategies as a hedge against market volatility because they are designed to carry less risk during periods of poor stock market performance. Low volatility investing is not a new concept but it has become increasingly popular given the high levels of market volatility experienced by equity investors during the 2008 financial crisis, the up-and-down movements in 2011, and the continued turbulence in 2012.
Previous literature shows that low volatility strategies have similar returns with substantially less volatility when compared with related market portfolios over the period 1968-2010. In a well constructed study, Ronnie Shah (DFA, 2011) explains why this finding should be interpreted with caution. First, low volatility strategies have substantial industry tilts. These strategies are concentrated in industries (apparel, groceries, toiletries and utilities) that are more stable in nature in contrast to industries that are more sensitive to market shocks (energy, technology and manufacturing). Second, low volatility strategies have higher exposure to the value premium and lower exposure to the market premium than comparable market indexes; this trade-off keeps average returns the same, since the value and market factors had similar average returns, but reduces volatility because the value factor has lower volatility than the market factor over the sample period.
The popular press has brought low volatility investing back to the investment community's attention as a hedge against market volatility. But simulations show that investors who wish to lower volatility are better off investing in a balanced stock and bond portfolio with equity exposure targeting a broadly diversified market-wide value strategy rather than sacrificing expected return by investing solely in a low volatility strategy.
Source: Understanding Low Volatility Strategies (2011): Ronnie H. Shah, DFA