S&P Dow Jones Indices (S&P DJI) produces a range of low volatility indices, covering various single-country and international markets. These indices offer a perspective on the returns of lower volatility equities and provide a basis for index-linked products and benchmarks globally. This practitioner’s guide:
- Explains the construction of low volatility indices;
- Identifies the role of broader market trends, valuations, interest rates, and sector exposures in determining their performance;
- Highlights the potential applications of low volatility strategies; and
- Summarizes the evidence for the existence and potential persistence of the so-called “low volatility anomaly.”
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Exhibit 1 illustrates an important aspect of low volatility indices: their potential to offer higher risk-adjusted returns than the market benchmark from which they were derived.
INTRODUCTION
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 1970s[1]—suggests that, across a wide range of time horizons, geographies, and market segments,[2] stocks with lower volatility have displayed higher risk-adjusted returns.
Meeting the need for low volatility benchmarks, S&P DJI’s 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 VolatilityIndex, launched in April 2011. Many more have been produced since.[3]
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. Exhibit 1 provides a summary for a selection of low volatility indices based on various benchmarks over the last 15 years, displaying the improved risk/return ratios of each low volatility index in comparison to its corresponding parent benchmark.
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 DJI. 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.
