What is low volatility investing and why should investors learn about it?
Low volatility is one of the factors investors can apply to select stocks that are more resilient to market downturns. There are low volatility factor funds and low volatility indexes.
The premise is that more investors are seeking higher rewards and therefore they buy into riskier stocks pushing up the prices of the riskier stocks and therefore leaving the less risky stocks at discounted prices.
A bit of a tall order maybe but there is a certain logic to it.
The measure most frequently used of the volatility of a stock by its beta. Beta is a number that represents how the stock price varies in comparison with the market.
- A stock whose price increases by 1% when the market goes up 1% has a beta of 1.
- A stock whose price increases by 0.5% when the market goes up 1% has a beta of 0.5
- A stock whose price decreases by 0.5% when the market goes up 1% has a beta of -0.5 etc
Working through this myself I am starting to wonder whether this is the best measure for volatility. I guess the logic is that every stock is affected by the market and the market will do what the market does. So when we want to measure the volatility of a stock we should do so using a measure of its volatility relative to the market.
One of the important aspects of Beta though is that it only works for small changes in price. Once the price has moved more than a few percentage points, the correlation with the market and hence the beta of the stock will change.
What goes down has to come back
Or so we hope.
The important point here is that since the market is in constant flux, and resetting and rebalancing itself after every move, a market position that has declined by 20% will then have to regain 25% to get back where it was.
Of course, the math gets worse the more your portfolio may have declined. For example, to recover from a 50% drop, your portfolio will need to double, i.e. regain 100% to get you back to where you started. While that isn’t impossible, it’s quite a tall order.
How does volatility perform over time?
To test the hypothesis on which low-volatility is based, let’s take a look at how stocks with different betas performed over the long-run.
A good universe to start with is the Standard and Poor’s 500 Index. This index tracks the prices of 500 of the largest and most financially sound stocks on the US stock exchange. Actually, the criteria the stocks have to meet to be included in the list are quite straightforward so there they are.
Criteria for inclusion in the Standard and Poor’s 500 Index
- Market capitalization must be at least $8.2 billion
- It must be a US-based company
- Must be listed on either the NYSE or NASDAQ
- Must be highly liquid – minimum monthly volume 250,000 shares traded every month
The list is maintained by a committee that considers changes every quarter. However, they try to avoid constant changes to which stocks are included on the list since the mere act of adding or dropping stocks from the list, moves the individual stock price. The weighting of each stock, i.e. the percentage that each stock contributes to the index is adjusted on an ongoing basis as prices move.
Since the Standard and Poor’s 500 Index is weighted by market capitalization, the bigger market cap stocks have a greater impact on the index. The top 10%, i.e. the top 50 stocks represent 54.4% of the total value of the index. Also, since all 500 stocks capture about 80% of the US markets, the top 50 stocks of the Standard and Poor’s 500 index captures around 43.5% of the US markets so it is a fairly good indicator of what the market is doing.
Top 50 stocks long-term annualized returns vs Beta
Here is the list showing their weighting in the index, their Beta values for the last 5-year period, and the annualized returns each delivered over the long-term with the available data.
1)Data source: Yahoo Finance, all calculations and charts by https://badinvestmentsadvice.com/
This is what the annualized returns look like when plotted against the Beta values.
I think this is why this kind of graph is called a scatter plot. To my eyes, I can’t see any kind of discernable pattern. To be fair this is not an equitable comparison since I did the calculations using the available data and some go back only 7 years while others go back more than 50 years.
Top 50 stocks last 5-years annualized returns vs Beta
Here are the annualized returns counting only the last 5 years from December 2015 to December 2020.
Again, I can’t see any kind of statistically significant pattern here. To prove the point if we add a linear regression line of best fit this is what we see.
Though there is no reason why we should be looking for a linear relationship, without getting into statistical detail, the low value of R squared shows that the data has a weak fit with a straight line.
As I say I want to avoid too much statistical detail but R squared varies from 0 to 1 where 0 indicates no pattern and 1 indicates a perfect fit. To get an R squared of 1 all the dots would be on the line. Generally, an R squared above 0.9 indicates a statistically significant and reliable fit.
Does low volatility deliver low returns?
I don’t think it would matter a great deal if we tried a curve for that matter. But more to the point whatever shape we try to fit it does look as if stocks with higher betas show greater returns which is actually the opposite conclusion to the basic premise of the low volatility strategy.
Reading the research on this topic, it seems that the low volatility approach only works over the very long term taking all phases of the economic and market cycle into account. So 5 years is clearly too short and what’s more the last 5 years from December 2015 to December 2020 have seen mostly rising stock prices.
Low volatility is one of the components of a fund management approach that is called Smart Beta. It is noteworthy that even reliable published sources on the topic show that opinions differ on Smart Beta in particular. But let’s not throw the baby out with the bathwater just yet.
Going back to our original definition, and the basic rationale for the low volatility strategy, we would probably see better results if we looked at long periods of either downwards or sideways market movement.
Annualized returns vs percentage difference high/low price
Working with available data, let’s try another measure of price volatility other than a stock’s market beta. Let’s see whether a relationship is more evident between the annualized returns and price volatility as measured by the percentage difference between the high price and the low price in a given time period.
In this instance, we are using monthly price data. This is what that looks like for our top 50 stocks.
Though you could argue there are still too few data points to draw any reliable conclusions, to my eyes there is a definite upward trend in the results. That uptrend is confirmed by the regression line that has a better value of R squared of 0.56 which is an improvement but is still far from being reliable.
Alpha and beta
Maybe all the analysis above is missing the main point.
What all fund managers seek in their investing strategy is to achieve returns that are greater than market returns. As explained in this article on the capital asset pricing model, alpha is the measure of excess returns with respect to the market returns.
Another way of saying this is that fund managers are in a constant quest for more and greater alpha. One of the principal advantages of low volatility assets is that they lose less of their value when the market declines than do more volatile assets. So there is a rationale for including low volatility stocks in your portfolio, either on a permanent or on an as-needed basis.
Low volatility ETFs
Many of the main fund providers offer low volatility equity and bond ETFs and some target dividend payments together with low volatility. This makes sense because some of the traditional low volatility stocks, such as utilities also tend to pay higher than average dividends.
It is true to say that generally, low volatility ETFs appeal to defensive investors, whether as a long-term position or for short-term defensive stances.
How to use low volatility investments
I will conclude by saying that low volatility is a factor that is best used in combination with other factors including growth, value, quality, and market capitalization in an overall factor-based investing approach.
Questions and Answers
Q. Is low volatility investing a good strategy?
A. Low volatility investing intends to minimize price declines when the market drops. On the other hand, it also tries to keep exposure to rising prices. It is a defensive strategy and is good for investors who have a low appetite for and tolerance of risk. It would not be a good long-term strategy for more aggressive investors.
Q. What are low volatility stocks?
A. Low volatility stocks are often found in utilities, drugs, and consumer staples sectors. They are often steady dividend-paying stocks and are considered safe-havens. Low volatility stocks also serve as a barometer for risk. When fund managers and investors start moving into low volatility stocks that is an indicator of a risk-off market. That indicates that fund managers and investors are becoming more cautious about the market.
Q. What is better, low volatility or high volatility?
A. That is a matter of personal preference. If an investor or trader is more aggressive and looking to make short or intermediate-term trades then they will generally be looking for higher volatility stocks. If an investor is more defensive and does not want to see significant declines in the prices of their positions, then it is better for them to be in low volatility stocks.
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|↑1||Data source: Yahoo Finance, all calculations and charts by https://badinvestmentsadvice.com/|