The low volatility factor is a well known effect that goes against many common assumptions that investors would have. A natural prior assumption would be that stocks with higher volatility compared to stocks with lower volatility should all else being equal, generate higher returns. This is based on the common assumption that higher risk should generate higher returns, as compensation for bearing that risk.
Counterintuitively, it is the stable lower volatility stocks that produced better risk-adjusted returns. Many investors and academics have termed this the low-volatility anomaly.
This had led to the construction and classification of the low-volatility factor. This factor has been shown to be:
The classification of this phenomenon as a factor therefore seems plausible and this has been actively harvested by the quantitative community for years.
Given the anomaly exists, the theory of why it exists has been explored and a few hypotheses have arisen, which are mostly behavioural in nature:
Low volatility is known as a defensive factor and has been shown to help overall portfolio performance during large market drawdowns as the low-volatility stocks help buffer the overall negative performance.
Low-volatility has also done very well since the global financial crisis, which has only helped increase the allure of the strategy. It is not surprising that during an era of quantitative easing and steady, consistent asset price growth that low-volatility strategies have done well.
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