Research Affiliates: True Grit: The Durable Low Volatility Effect

October 30, 2014

The outlook for low volatility strategies remains promising.

One of the basic tenets of finance is that investors are compensated for taking risk. For equity markets, that means that high volatility stocks are expected to outperform low volatility stocks. But that hasn’t happened. Low-risk stocks have historically outperformed high-risk stocks.

Will this low volatility effect persist? Renewed interest in low volatility strategies has led to higher demand for low volatility stocks, and high demand for low volatility stocks could conceivably eradicate the return premium once and for all. Nonetheless, the effect has proven robust across time periods and markets, and, unless contrarian investing paradoxically becomes the norm, there is good reason to believe that it won’t go away anytime soon.

Historical Record
The low volatility effect has been known so long1 and studied so extensively that there is little danger it will be discredited as a statistical fluke or a by-product of incomplete or erroneous data. Low volatility stocks tend to trade at a discount to the broad market and, of course, to high volatility stocks; the magnitude of the discount is highly variable,2 but the low volatility effect has nonetheless been durable (see Table 1). 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.

Simulated Low Votality Performace

The historical record, then, is reassuring. Nonetheless, we’ve all seen rapid, even cataclysmic, change in other situations. Institutional arrangements can break down, technological advances can disrupt the balance of power, regulatory reforms can impede capital flows or raise the cost of trading, and, in principle, people can learn from experience. Even if we resolutely assume that radical change is unlikely, we cannot offer an opinion on the continuance of the low volatility effect without understanding the conditions that have made it possible thus far.



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