Basic financial theory is predicated on the idea that higher-risk investments should be priced to offer commensurately higher returns. Unfortunately for the theory, a growing body of empirical evidence—accumulated since the 1970s1—suggests that, across a wide range of time horizons, geographies, and market segments, stocks with lower volatility have displayed higher risk-adjusted returns.
Meeting the need for low volatility benchmarks, S&P Dow Jones Indices’ low volatility indices track the performance of a portfolio of the least volatile stocks selected from a given benchmark universe, such as the S&P 500. Indeed, the first-ever low volatility index was the S&P 500 Low Volatility Index, launched in April 2011. Many more have been produced since.
The performance and risk/return characteristics of these indices, both over hypothetical back tests and subsequent to their launch dates, provide further confirmation that lower-risk stocks can offer superior performance characteristics.
In light of the growing popularity of products (such as ETFs) offering access to low volatility strategies, a growing body of research identifying and quantifying the drivers of low volatility performance has emerged. These include the role of sectoral allocations, interest rate sensitivities, and equity valuations. In what follows, we shall briefly summarize the salient points that emerge from this research.
More directly to practitioners’ interests, we shall also examine the portfolio applications of low volatility strategies, in either a multi-factor or multiasset context. We conclude by addressing the question of whether or not the so-called “low volatility anomaly” of higher risk-adjusted returns might continue.
Note that while our results extend in spirit to many similar equity strategies, our focus will be restricted to the indices produced by S&P Dow Jones Indices. Accordingly, we begin with a summary of the methodology used to construct our low volatility indices, and a brief examination of the practical consequences of using historical volatility rankings to form equity portfolios.