low-volatility investing

The low-volatility anomaly was already discovered in the early 1970s, yet it only became a popular investment style after the 2008 global financial crises. The first tests of the Capital Asset Pricing Model (CAPM) showed that the risk-return relation was too flat.Black, F., Jensen, M. C., & Scholes, M. (1972). The capital asset pricing model: Some empirical tests. Studies in the theory of capital markets, 81(3), 79-121.Fama, E. F., & MacBeth, J. D. (1973). Risk, return, and equilibrium: Empirical tests. Journal of Political Economy, 81(3), 607-636.
Two decades later, in 1992 the seminal study by Fama and French clearly showed that market beta (risk) and return were not related when controlling for firm size.Fama, E. F., & French, K. R. (1992). The cross‐section of expected stock returns. The Journal of Finance, 47(2), 427-465. Fisher Black argued that firms or investors could apply leverage by selling bonds and buying more low-beta equity to profit from the flat risk-return relation.{{Cite journal|last=Black|first=Fischer|date=1993-10-31|title=Beta and Return|url=https://jpm.pm-research.com/content/20/1/8|journal=The Journal of Portfolio Management|language=en|volume=20|issue=1|pages=8–18|doi=10.3905/jpm.1993.409462|s2cid=154597485 |issn=0095-4918}} In the 2000s more studies followed, and investors started to take notice.Ang, A., Hodrick, R. J., Xing, Y., & Zhang, X. (2006). The cross‐section of volatility and expected returns. The Journal of Finance, 61(1), 259-299.Clarke, Roger, Harindra de Silva & Steven Thorley (2006), “Minimum-variance portfolios in the US equity market”, Journal of Portfolio Management, Fall 2006, Vol. 33, No. 1, pp.10–24.{{Cite journal|last1=Blitz|first1=David|last2=van Vliet|first2=Pim|date=2007|title=The Volatility Effect: Lower Risk Without Lower Return|journal=Journal of Portfolio Management|language=en|volume=34|issue=1|pages=102–113|ssrn=980865|doi=10.3905/jpm.2007.698039|s2cid=154015248 }} In the same period, asset managers such as Acadian, Robeco and Unigestion started offering this new investment style to investors. A few years later index providers such as MSCI and S&P started to create low-volatility indices.

File:Volatility sorted portfolios 1929 2023.png

Low-volatility investing is gradually gaining acceptance due to consistent real-life performance over more than 15 years, encompassing both bull and bear markets. While many academic studies and indices are based on simulations going back 20-30 years, some research spans over 90 years, showing low-volatility stocks outperform high-volatility stocks in the long run (see image). Since low-volatility securities tend to lag during bull markets and tend to reduce losses in bear markets, a full business cycle is needed to assess performance. Over shorter time periods, such as one year, Jensen's alpha is a useful performance metric, adjusting returns for market beta risk. For instance, a low-volatility strategy with a beta of 0.7 in a 10% rising market would be expected to return 7%. If the actual return is 10%, Jensen's alpha is 3%.

Any investment strategy can lose effectiveness over time if its popularity causes its advantage to be arbitraged away. This could apply to low-volatility investing, highlighted by the high valuations of low-volatility stocks in the late 2010s.{{Cite web|url=https://www.researchaffiliates.com/en_us/publications/articles/442_how_can_smart_beta_go_horribly_wrong.html|title=How Can "Smart Beta" Go Horribly Wrong?|website=researchaffiliates.com|access-date=2019-07-24}} Still, David Blitz showed that hedge funds are at the other side of the low-volatility trade, despite their ability to use leverage. Others state that low-volatility is related to the well-known value investing style. For example, after the dotcom bubble, value stocks offered protection similar to low volatility stocks. Additionally, low-volatility stocks also tend to have more interest rate risk compared to other stocks.{{Cite web|url=https://dash.harvard.edu/bitstream/handle/1/16244348/baker-m%2Cwurgler_comovement_RAPS.pdf?sequence=1&isAllowed=y|title=Comovement and Predictability Relationships Between Bonds and the Cross-Section of Stocks|last1=Baker|first1=Malcolm|last2=Wurgler|first2=Jeffrey|date=2012|website=|archive-url=|archive-date=|access-date=}} 2020 was a challenging year for US low-volatility stocks as they significantly lagged behind the broader market by wide margins.{{Cite web|last=|first=|work=The Wall Street Journal |date=18 September 2020|title=Some investors tried to win by losing less-they lost anyway|url=https://www.wsj.com/articles/some-investors-tried-to-win-by-losing-less-they-lost-anyway-11600441199|archive-url=|archive-date=|access-date=}}{{Cite web|last=Wigglesworth|first=Robin|date=2021-03-22|title=A fallen star of the investment world|url=https://www.ft.com/content/c5bc2880-07f0-4998-85c5-be4300a32427|access-date=2021-09-15|website=www.ft.com|language=en-GB}} Criticism and discussions are primarily found in various academic financial journals, but investors take notice and contribute to this debate.{{Cite web|url=https://www.fortunefinancialadvisors.com/blog/compendium-of-low-volatility-articles/|title=Compendium of Low Volatility Articles|last=Hamtil|first=Lawrence|date=2019-07-22|website=Fortune Financial Advisors|language=en-US|access-date=2019-07-24}}{{Cite web|url=https://alphaarchitect.com/2018/07/12/deconstructing-the-low-volatility-low-beta-anomaly/|title=Deconstructing the Low Volatility/Low Beta Anomaly|last=Swedroe|first=Larry|date=2018-07-12|website=Alpha Architect|language=en-US|access-date=2019-07-24}}

• Low-volatility anomaly
• Investment style / Style investing
• Value investing
• Momentum investing

A couple of books have been written about low-volatility investing:

• Eric Falkenstein, Wiley Publishers 2011, Finding Alpha: The search for alpha when risk and return break down. {{ISBN|9780470445907}}
• Peter Sander, McGraw-Hill 2013, All about low-volatility investing. {{ISBN|9780071819848}}.
• Eric Falkenstein, 2016, The Missing Risk Premium: Why low-volatility investing works. {{ISBN|1470110970}}
• Pim van Vliet, Jan de Koning, Wiley Publishers 2017, High Returns from Low Risk: A Remarkable Stock Market Paradox. {{ISBN|9781119351054}}.

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Category:Investment