About UsCONTACT US
what is the low volatility factor for quantitative equity portfolio investing
Back to topic: Learn about equity style factors

STRATxAI

February 2024 · 5 min read

Low-Volatility Factor

Research
Educational

What is the low-volatility factor ?

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.

  • higher volatility --> higher returns

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:

  • consistent through time
  • widespread across geographies/countries
  • transfers to other asset classes

The classification of this phenomenon as a factor therefore seems plausible and this has been actively harvested by the quantitative community for years.

Performance of the low-volatility factor compared to the value factor.
Performance of the low-volatility factor compared to the value factor. Source: FactorResearch
Reasons for the existence of the low-volatility factor

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:

  • lottery effect, investors have an urge to buy stocks that exhibit lottery-like distribution. This means they purchase stocks with high-volatility at premiums to their fair price and thus allow low-volatility stocks to benefit from higher future returns.
  • Various fund managers, via their structure and rules, may not be allowed to employ leverage to enhance their returns. They instead resort to investing in stocks with higher beta (to hopefully generate extra returns) and again pay premium prices for such stocks.
  • Some can argue that incentivization plays a role whereby fund managers who are benchmarked are only rewarded for beating the benchmark. They therefore again skew their investment decisions towards stocks with higher beta and pay price premiums for such stocks.
  • Potential behavioural explanation where investors tend to gravitate towards news-worthy or attention-grabbing stocks, which tend to be higher beta stocks, and therefore overpay again for these stocks.
In what periods does low-volatility do well ?

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.

PreviousNext

More in

Learn about equity style factors

Style Factors
July 06, 2022 · 5 min read