U.S. Equities

The Low-Volatility Anomaly

Low volatility investing is one of the largest and most surprising opportunities to earn excess returns (alpha) that has ever been identified.
October 2017

Equities with lower than average volatility have delivered superior returns, both absolute and risk-adjusted, over a period spanning many decades. Investors should consider an allocation to strategies that take advantage of the so-called low-volatility anomaly.

Finding opportunities through the low-volatility anomaly

Low-volatility stocks — those with less price variability than the average stock in the market — deliver higher returns than other stocks. This is an empirical fact, at least insofar as the last 90 years or so are concerned. And it is one of the most surprising market anomalies (a result not predicted by theory) ever found. It’s surprising because, as almost everyone believes, return is supposed to be related to risk so that higher-risk stocks should deliver higher returns and lower-risk stocks should deliver lower returns. The low-volatility anomaly stands this sensible theory on its head and, if it persists in the future, may provide a remarkable opportunity to make outsize returns.

Basic data

Before getting into the history of the low-volatility anomaly and how we apply it in today’s markets, let’s briefly review the data behind this surprising finding. While low-volatility pioneers Nardin Baker and Robert Haugen (2012) have shown that the low-volatility anomaly holds in every country’s equity market for which data can be collected, we focus on the United States. Figure 1 shows the raw (not risk adjusted) returns on quintiles of stocks sorted by volatility over the period 1970–2011. The relationship that emerges is the opposite of what common sense and financial theory would lead us to expect: low-volatility stocks outperformed even before adjusting for risk. Other researchers have shown that this finding is consistent over longer periods.

Figure 1: Equity performance by quintiles of volatility, 1970-2011

Figure 1: Equity performance by quintiles of volatility, 1970-2011

Source: FactSet. Includes 1,000 largest U.S. stocks by market cap. Equal-weighted monthly rebalances, compounded. Volatility defined as 36-month price return volatility.

Risk-adjusted returns follow an even more dramatic pattern. Figure 2 shows the Capital Asset Pricing Model (CAPM) alphas (returns after adjusting for each stock’s beta or “market” risk) for each quintile.

Figure 2: CAPM alphas of volatility quintiles, U.S. equities, 1970–2011

Figure 2: CAPM alphas of volatility quintiles, U.S. equities, 1970–2011

Source: FactSet. Includes 1,000 largest U.S. stocks by market cap. Equal-weighted monthly rebalances.

The alpha of more than 5% of the lowest volatility quintile (a reasonably well-diversified strategy of 200 large-cap stocks) is extraordinary. Even more striking is the 12.6% spread between the performance of the first and the last quintile. Because beta does not capture all of the risk in a portfolio, we confirm these results by calculating the Sharpe ratio (total return divided by volatility as measured by standard deviation) as shown in Figure 3.

Figure 3: Sharpe ratios (annualized) by quintiles of volatility, 1970–2011

Figure 3: Sharpe ratios (annualized) by quintiles of volatility, 1970–2011

Source: FactSet. Includes 1,000 largest U.S. stocks by market cap. Equal-weighted monthly rebalances. Volatility defined as 36-month price return volatility.

When portrayed as Sharpe ratios, returns are still monotonically decreasing as risk increases, and the size of the effect is still substantial — despite the theory that financial markets should reward investors for taking risk predicts the opposite.

How can this be?  Download the full report to continue reading.

Related Capability

Learn more about our U.S. Equity capabilities.

The Russell 1000® Index measures the performance of the large-cap segment of the U.S. equity universe. It is a subset of the Russell 3000® Index and includes approximately 1,000 of the largest securities based on a combination of their market cap and current index membership. The Russell 1000® represents approximately 92% of the Russell 3000® Index. The Russell 1000® Index is constructed to provide a comprehensive and unbiased barometer for the large cap segment and is completely reconstituted annually to ensure new and growing equities are reflected.

Related articles
No posts matching your criteria