Could Low Volatility Stocks Improve your Returns?

Wesley Gray |

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Investing in strategies that exploit the low volatility anomaly have grown in popularity in recent years. While low volatility based strategies may not necessarily beat the return of a market cap weighted index, they will likely deliver significantly reduced volatility. This reduction in volatility generally results in improved sharpe ratios vs. the market cap weighted index. By incorporating an asset with a better risk/return relationship into one’s portfolio, the overall risk adjusted return of the portfolio can be improved. Let’s consider the impact of low volatility stocks on portfolio performance. 

Basic Low-Volatility Portfolio Stats

For this analysis, I use MSCI USA Minimum Volatility Index returns. I've selected this index solely because it provides the longest series of returns for low volatility - which is to say, freely available (MSCI provides back generated monthly index values starting 5/31/1988 on their website). As the MSCI Minimum Volatility Indexes are formed through a constrained optimization process, it is likely that these back-generated returns overstate the excess returns that will be realized going forward.

Returns are from 5/31/1988 to 7/31/2014. Cap-weighted market and T-Bill returns are from the Ken French data library.

Monthly Return Statistics 1 month T-bill US Mkt Cap Wt MSCI US Min Vol
Geometric Mean (annualized) 3.40% 10.42% 9.76%
Standard Deviation (annualized) 0.71% 14.95% 11.58%
Sharpe Ratio   0.52 0.58

The results are hypothetical results, and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

For this time period, the low volatility index provides a reasonable return at lower volatility than the market, resulting in a higher sharpe ratio.

Can Volatility be Lowered Even More?

Consider a simple portfolio that is 60%/40% US Mkt Cap Wt/1 month T-bill and we replace the equity portion with low volatility stocks (rebalanced monthly to maintain a constant allocation). The summary statistics are presented below:

Monthly Return Statistics 60/40 Mkt Cap 60/40 Min Vol
Geometric Mean (annualized) 7.85% 7.35%
Standard Deviation (annualized) 8.98% 6.97%
Sharpe Ratio 0.52 0.58

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

By replacing the market cap weighted stocks with low volatility stocks, both the return and volatility are reduced with the end result being a lower risk, lower return portfolio.

Can we Engineer a Better 60/40 Portfolio?

To effectively incorporate low volatility stocks into the portfolio, they need to be scaled to an equivalent risk level as the asset they are replacing. Often this is thought of as requiring leverage, but in the context of a lower risk portfolio, all that is needed is to increase the equity allocation to bring portfolio risk back to the same risk level.

Consider the portfolio below, which compares a 60/40 mkt/bond portfolio with a 77/23 low-vol stock/bond portfolio:

Monthly Return Statistics 60/40 Mkt Cap 77/23 Min Vol
Geometric Mean (annualized) 7.85% 8.40%
Standard Deviation (annualized) 8.98% 8.93%
Sharpe Ratio 0.52 0.58

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

After increasing the allocation to 77% low volatility stocks, and reducing the T-bill allocation, the portfolio risk is about the same as the 60/40 market cap portfolio, while providing a higher return.

Is it Time to Jump into Low-Volatility Stocks?

You may now feel ready to jump on the bandwagon and add low volatility equities to your portfolio by replacing some (or all) of your market cap-weighted stocks with low volatility stocks and increasing your equity allocation. However, this isn’t the full story…

Let’s consider a few more assets and go beyond simple volatility and consider tail risks. Here’s another table of return statistics for the same time period including equal weighted decile value stocks (10 E/P) and momentum stocks (12-1 momentum stocks.)

Monthly Return Statistics 1 month T-bill US Mkt Cap Wt MSCI US Min Vol Decile 10 E/P Decile 10 Mom
Geometric Mean (annualized) 3.40% 10.42% 9.76% 16.45% 18.61%
Standard Deviation (annualized) 0.71% 14.95% 11.58% 18.98% 22.85%
Sharpe Ratio   0.52 0.58 0.72 0.72
Max Drawdown   -50.39% -41.59% -62.05% -59.29%

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Both value and momentum deliver higher returns, higher volatility, and larger drawdowns; however they also have the highest sharpe ratio. Going back to our simple portfolio, let’s create equivalent volatility portfolios individually incorporating each asset as a replacement for market cap weighted stocks.

Monthly Return Statistics 60/40 Mkt Cap 77/23 Min Vol 47/53 Decile 10 E/P 39/61 Decile 10 Mom
Geometric Mean (annualized) 7.85% 8.40% 9.86% 9.78%
Standard Deviation (annualized) 8.98% 8.93% 8.90% 8.92%
Sharpe Ratio 0.52 0.58 0.72 0.72
Max Drawdown -33.04% -33.20% -33.75% -27.24%

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

The value and momentum portfolios produce the highest returns, which is expected given their sharpe ratios. Maximum drawdowns are similar except for the momentum portfolio–combining momentum stocks with bonds greatly reduces the volatility associated with these volatile stocks. Since both the value and momentum portfolios utilize reduced equity allocations, it is easier to incorporate other uncorrelated assets without running out of allocation “room.” Additionally, there is no need for leverage in portfolios targeted for higher risk.

Once again, value and momentum demonstrate why they are considered the premiere anomalies.

So do Low Volatility Stocks have a Place in Portfolios?

Consider the below correlation matrix:

Correlation Matrix
  US Mkt Cap Wt MSCI US Min Vol Decile 10 E/P Decile 10 Mom
US Mkt Cap Wt 1.00 0.91 0.79 0.79
MSCI US Min Vol   1.00 0.65 0.58
Decile 10 E/P     1.00 0.81
Decile 10 Mom       1.00

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

The minimum volatility index has lower correlation to value and momentum than they do to each other or the cap weighted market. Low volatility equities still provide improved risk/return over the market cap weighted index and also provide a diversification benefit. For portfolios targeting conservative to moderate risk levels, including an allocation to low volatility stocks along with value and momentum stocks seems like a reasonable approach. I’ll leave you with the following table illustrating a 60/40 stock/t-bill portfolio where the equity allocation is equally split between minimum volatility, value, and momentum:

Monthly Return Statistics 60/40 (val/mom/vol) 
Geometric Mean (annualized) 10.77%
Standard Deviation (annualized) 9.61%
Sharpe Ratio 0.77
Max Drawdown -35.38%

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

 

Written by Chris Scott

For more from Wesley Gray and his investing and finance team, check out their blog at Alpha Architect.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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