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Factor Investing: The "Low Volatility" Factor

  • Posted by: ,  Chief Executive
  • 20 August 2018
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The "Low Vol" factor as a driver of equity stock returns

The "low volatility" risk factor seeks to exploit the historic tendency for securities with smaller price fluctuations to give higher returns. The same can be said for "low beta" stocks. Why these factors generate excess returns is not clear. One possibility is that, for equity managers charged with beating an index, low beta stocks may be seen as "risky" stocks to hold in a rising market. Therefore a higher risk premium might (ironically) be required in order to hold them.

The factor investing research papers listed below summarise the findings on the low vol / low beta factor and deal with some common issues or objections, such as over-crowding and over-valuation. We finish the list of factor investing papers with three which provide a full overview of the different equity risk factors.

low volatility factor

Low Volatility: A Practitioner's Guide (S&P Dow Jones Indices, Jun 2018) 
This guide summarizes the evidence for the so-called "low-volatility anomaly" and examines the possible implementation of low vol strategies, explaining the construction of S&P DJI's own low volatility indices.

Factor Investing: What's the big deal with low volatility equities? (Aon Hewitt)
This report is part of a broader Aon research project on factor investing, which focuses on the key factor anomalies identified in academic papers. This report shows that low volatility investing has generated superior, long-term risk-adjusted equity returns. The authors discuss behavioural bias, rebalancing and investor constraints as being commonly-offered explanations for this anomaly.

Low volatility investing: Standing out from the crowd (Invesco Europe, Apr 2018)
(For compliance reasons, this paper is only accessible in the UK and Europe)
Invesco examines the fascinating history of low-vol investing, describing how the concept has moved from the margins to the mainstream. The authors ask whether the strategy is overcrowded and examine the threats and opportunities to the sector.

How to Overcome Overcrowding in Low Volatility Investing (Intech Investments)
(For compliance reasons, this paper is only accessible in certain geographies)
Intech points out in this report that history is littered with stories of strategies that have attracted significant capital, resulting in higher valuations and depleted capacity. The fear of overcrowding is quite rational, but this paper seeks to dispel some of those fears. The authors demonstrate that, in this instance, we are not dealing with a homogeneous class of strategies, all subject to the same risks.

Should You Care About Valuations in Low Vol Strategies? (Intech Investments)
(For compliance reasons, this paper is only accessible in certain geographies)
Intech believes that the fear of factor crashes from stretched valuations is based on an overgeneralization of such strategies. Their analysis shows that risk and valuation do not have a clear relationship. They argue that it is better to use a low-vol allocation as a strategic decision rather than to treat it as a tactical allocation. Even if valuations are expensive, low vol strategies may yield a net performance benefit, given their protective characteristics at times of market drawdowns.

Low Volatility in historical perspective: Fund investing since 1774 (Robeco)
In this 20 page document, Robeco looks back at the last 200-plus years from a low-volatility perspective. The authors suggest that a root cause of the low-risk anomaly is the modern focus on relative performance, but that prudent investment virtues are still required; low volatility strategies are a great idea, but timing is important as well.

The Low Volatility Factor in U.S. High Yield Corporate Bonds (SPDJI, Jan 2017)
This paper from S&P Dow Jones shows that the concept of low risk investing can be applied, not just to equity selection, but also to fixed income portfolios. In particular, the authors demonstrate a helpful screen to filter out riskier bonds.

SSGA Long-Term Smart Beta Estimated Forecasts, Jan 2018
It is rare to find investors who have developed a model for forecasting the returns from "smart beta" factors. In this paper, State Street Global Advisors provides forward-looking estimates of excess returns from each individual equity factor. These are generated based on an examination of current factor "valuations" and historical return premia. The research focuses on four factors: Low Volatility, Value, Quality and Size.

Understanding the role of alternative risk premia (Wellington Management, 2018)
Looking across a range of asset classes, Wellington examines four types of alternative risk premia that are "historically persistent" and "potentially profitable". The paper discusses the objective of each strategy and shares their views with regard to the challenges of capturing the effect and the best means of implementation and portfolio construction.

Factor Investing: An Academic Source of Excess Returns (Savvy Investor, 2018)
This 24-page special report is designed as a go-to resource for investors considering the adoption of a factor investing approach. The paper explains the origins of the different risk factors and lists the best academic and commercial papers for reading up on each factor.

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