It's a bit of mind-bender, but low volatility could keep outperforming broader markets.
[This article originally appeared on our sister site, ETF.com Europe.]
Investors are hardwired to believe that taking higher risks means being rewarded in the long run with higher returns. Yet low volatility stocks have been proven by several academic papers to outperform high volatility stocks. But as investors flood into this strategy, industry participants have questioned whether this outperformance will last.
Minimum volatility was found to be the worst performing strategy in July and June, according to EDHEC Risk Institute’s ERI Scientific Beta report. However, the research house also found that minimum volatility delivered the best risk-adjusted performance from January to July and has delivered positive performance of 11 percent since inception in 2002.
Peter Sleep, portfolio manager at 7IM, said minimum volatility does have an important role to play in an investor’s portfolio.
“It is low cost, it beats the market, and it has lower volatility than the market,” he said.
“The real problem with the minimum volatility strategy is that it is difficult to understand, which can present a difficulty when the strategy underperforms, which is roughly one third of the time, particularly if the underperformance persists,” he added.
It may be easier to understand prolonged underperformance of an active manager picking stocks and bonds, rather than completely understand why a minimum volatility strategy is not doing well.
But can low volatility’s continued outperformance last?
A new paper from Feifei Li and Philip Lawton from Research Affiliates believes it can, and outlines five reasons why.
1) Proven historical record
The Research Affiliates paper argues that the “low volatility effect” has been known for so long and studied so well that there is little danger it could be discredited as a statistical fluke or a result of a mistake in the data. Lawton and Li said that, although the low volatility premium to the broad market will vary, the low volatility effect has been robust over time.
“The fact that simulated low volatility strategies have produced excess returns in many countries implies that the effect is deeply embedded in global capital markets,” they wrote.
2) Riskier assets don’t always yield higher reward
The notion that investing in higher risk stocks is bound to line investor pockets over the long term is an “article of faith” among active managers, according to the paper. Like people who work longer hours, they will also get paid more, which suggests that long term investments will also do well, and not just higher risk investments.
Lawton and Li said that calling the low volatility effect an “anomaly” implies it must be explained while still believing in the traditional higher risk, higher return model. Instead, they said, we can look to behavioural finance for answers as to why low volatility outperforms.