Although the low volatility anomaly was first documented more than 40 years ago, the fearful and volatile market environment of the years following the 2008 financial crisis propelled the concept to the forefront of market participant interest. In recent years, low volatility has been a hot topic in investment discourse, and this has resulted in innovative financial instruments that exploit the anomaly. Importantly, the low volatility anomaly is not limited to one or two markets, but rather it seems to be universal.
The S&P 500® Low Volatility Index is a passive vehicle that seeks to exploit this phenomenon systematically. Since 1991, the index has outperformed the S&P 500, and it has done so at a substantially lower level of volatility (see Exhibit 1). In Canada, the performance differential between the country’s benchmark index and its low volatility counterpart is even more pronounced (see Exhibit 2).
There are different ways to construct a low volatility portfolio, and they will, of course, produce different portfolio characteristics. One common assumption behind these methodologies is that low volatility is a factor of return, in the same sense that small size or cheap valuation are regarded as factors of return. This is a difficult—indeed, anomalous—assumption, since it seems to contradict what “everyone knows” about risk and return. Anyone who studies finance learns early on that risk and reward go hand in hand, and that with higher expected returns comes higher risk. Therefore, low volatility portfolios, which are by definition less risky than the market average, should underperform.
Against this logical theory, we have only some inconvenient evidence. Exhibits 1 and 2, for example, show that the low volatility indices not only outperformed their respective benchmarks (by 0.99% and 4.11% on an annual compound growth basis for the U.S. and Canada, respectively), but they did so with a significantly lower monthly standard deviation (23% lower in the U.S. and 32% lower in Canada). Other examples abound. It is no wonder that academics regard “the long-term outperformance of low-risk portfolios [as] perhaps the greatest anomaly in finance.”