Yes, was the resounding answer. If anything, the results are even stronger, defying the notion that once an anomaly is discovered it tends to be arbitraged away. For us there is no doubt, the low-volatility anomaly is alive and kicking, just as it was 10 years ago.
Over the last 10 years, we have refined and developed our global low-volatility equity strategy. Nonetheless, fundamentally it remains the same - tailored to benefit from the low-volatility anomaly delivering on its objectives - namely, generating higher risk-adjusted returns than the global market capitalisation-weighted benchmark over the medium to long term.
To mark this tenth anniversary, we have published a Practical Guide to Low-Volatility Investing' . It provides an overview of this systematic investment process that can help investors diversify their portfolios and target higher risk-adjusted returns.
In the last decade, low-volatility investing has become an investment style in its own right with the launch of a number of low-volatility equity funds. These funds invest in low-risk stocks and the managers use different risk measures to identify the stocks the fund can buy.
Some funds are designed simply to be less risky than the traditional cap-weighted benchmark indices while promising higher risk-adjusted returns over the medium to long term. Others are designed to outperform the same benchmarks over the medium to long term despite being less risky.
However, all these funds have one thing in common: They are founded on the persistence of the low-volatility anomaly in order to meet their objectives of higher returns despite lower risk, or even just simply of higher risk-adjusted returns relative to the benchmark.
The low-volatility anomaly, or how the quiet 'uns pack a bigger punch...
The ‘low-volatility anomaly’ refers to the counter-intuitative fact that less volatile stocks tend to generate higher-than-expected returns given their level of risk.
First evidence of this anomaly was provided by Haugen and Heins in 1972. They used historical equity returns to show that, between 1926 and 1969, portfolios investing systematically in the least volatile US stocks would have delivered much larger returns than expected from their low level of risk.
Conversely, they showed that portfolios invested in the most volatile stocks would have significantly disappointed in terms of performance. To begin with the academic community had trouble accepting these findings as they refuted a basic principle in finance, which stated that: Higher risk should be rewarded with higher return, as advocated by Treynor in 1962 with the Capital Asset Pricing Model (CAPM). However, that was wrong and the low-volatility anomaly has since been confirmed empirically by numerous research studies.
What started – and is still referred to – as an anomaly, clashing with the basics of finance, can actually be explained by taking into account the fact that the hypothesis used in the formulation of basic financial theory is based on simplifications, not actually verified in the real world.
Why is the low-volatility anomaly persistent ?
(i) Contrary to common assumptions, investors face a number of constraints when investing, such as the amount of leverage they may use, or the reliance on short-selling techniques to arbitrage pricing anomalies.
(ii) Investors have different investment objectives; they do not necessarily seek to maximise absolute returns and reduce volatility. For instance, most professional fund managers are assessed on returns generated relative to a benchmark given a specific level of risk.
(iii) The assumption that investors face no transaction costs or taxes and that markets are perfectly divisible and liquid does not, as we all know, hold true.
(iv) Investors have different investment horizons. One only needs to consider the generational gap between younger and older investors – and their different priorities – to grasp that.
Finally, the idea that investors are in possession of complete and rational information has been challenged by behavioural theory. Indeed, we know that most investors are subject to many cognitive biases such as representativeness bias, overconfidence or preference for lotteries.
That all these issues run counter to the fundamental assumptions that underlie basic financial theories can lead, in ways that have been discussed by researchers, to the low-volatility anomaly and thus to the fact that higher risk is not always rewarded by higher return.
Low volatility is everywhere
The low-volatility anomaly has existed for a long time and can be applied to many asset classes such as fixed income, for instance. In 2011, our research demonstrated empirically that the low-volatility anomaly can be observed in every sector of activity and, as such, it is not a sector effect.
The least volatile stocks of every sector have had higher returns than should be expected from their level of risk, and the most volatile stocks of every sector have had lower returns than should have been expected.
These results were eventually updated and published in our 2015 paper, “Low-risk anomaly everywhere: Evidence from equity sectors”, published as a chapter in the book “Risk-Based and Factor Investing”, ISTE and Elsevier.
Accordingly, the low-volatility anomaly is even observed in more volatile sectors such as information technology or industrials. Given that the least volatile stocks from different sectors have different absolute levels of volatility, it is important to construct a diversified portfolio invested in the least volatile stocks of each sector.
Simply selecting those stocks with the lowest absolute level of volatility would result in a non-diversified portfolio, concentrated in stocks from those sectors with the lowest absolute level of volatility.
Indeed, investing in the least volatile stocks from all sectors adds diversification and delivers higher risk-adjusted returns than relying solely on a portfolio strongly biased towards the least volatile sectors. Low-volatility strategies that invest across all sectors tend to be more robust in terms of risk-adjusted returns, even if they may be somewhat more volatile than those that focus only on the least volatile sectors.
It is perhaps not difficult to understand why creating a permanent sector bias is not a good idea. With the benefit of hindsight, we know that economically sensitive sectors such as financials, consumer discretionary, information technology, industrials and materials tend to outperform in the early phase of the cycle.
Later, in mid-cycle, when activity and profit growth peaks, credit growth is too strong and policy is neutral, sectors such as information technology and industrials tend to do well, while materials and utilities usually perform poorly.
In turn, late in the cycle, when activity moderates, policy is tight, credit tightens, earnings come under pressure and inventories grow as sales growth fades, defensive and inflation-resistant sectors such as materials, consumer staples, healthcare, energy and utilities tend to perform better.
During the recession phase, with equity markets performing poorly, activity falling, credit drying up, profits declining, inventories and sales falling and policy easing, consumer staples, utilities and healthcare tend to do well, while information technology and industrials usually underperform.
While not all cycles are equal, sector rotation has been following this pattern for decades. What makes it difficult to profit from sector rotation is being able to forecast the changes in the business cycle itself accurately enough.
The low-volatility anomaly in every sector: 10 years later
Our new practical guide to low-volatility investing provides analysis showing how low-volatility strategies that diversify by investing in the least volatile stocks of all sectors can more easily avoid being over-exposed to the business cycle rotation in sector returns.
They also profit from the robust finding that the highest risk-adjusted returns, and most often, even the highest absolute returns, can be found in the least volatile stocks of all sectors relative to their respective sector peers.
Combining the best of both worlds: Factor and sustainability investing
For our low-volatility strategies, sustainable investing can be treated as a third dimension in addition to the return and the risk. Looking ahead, investors will be able to tailor their investments based on three major objectives: The return they expect, the risk they are willing to take, and the sustainable objectives they seek.
Quantitative techniques are well suited for integrating sustainability goals: BNP Paribas Asset Management is convinced that by integrating sustainability into our investment process, we will gain a deeper and richer understanding of the risks that we face. Consequently, over the longer term, we will make better-informed decisions for our clients.
Moreover, as we transition from the exclusion-only approach, our integration process now allows us to reach the core investments of our customers and accompany them in having a stronger positive impact on our world.
For the full analysis of our approach to low-volatility investing, refined and developed over the last 10 years, read our Practical Guide to low-volatility investing
Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice.
The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.
Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).
Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.