EC Did Low-Volatility Strategies Fail Investors?

February’s market break caught many investors by surprise. Many who thought they had girded their portfolios against volatility were shocked by the size of their losses. “Where’s my protection?” was an oft-heard complaint.

Most of the grumbling seemed to arise from confusion about so-called “low-volatility” products.

The Low-Vol Anomaly

First of all, low-volatility, or “low-vol,” funds aren’t designed to be hedges against sudden market breaks. They’re instead constructed to exploit a phenomenon known as the “low-volatility anomaly.”

Most investors, as well as many advisors steeped in the Capital Asset Pricing Model, suppose a positive relationship between risk and return. CAPM would have us believe that we’ll be rewarded with higher returns when we invest in higher-risk (read: high-volatility or high-beta) issues.

But empirical research conducted over the past five decades seems to belie this notion. In fact, low-vol stocks have been found to deliver higher risk-adjusted returns and alpha than most high-vol paper. That’s the anomaly.

You can see this incongruity in action by comparing the performance of the PowerShares S&P 500 Low Volatility ETF (NYSE Arca: SPLV ) and its opposite number, the PowerShares S&P 500 High Beta ETF (NYSE Arca: SPHB). Each fund carves out 100 stocks from opposite ends of the volatility spectrum within the S&P 500 Index. SPLV selects stocks with the lowest daily standard deviation over the past year while SPHB grabs those issues with the highest beta coefficients.

As Figure 1 illustrates, the low-vol slice of the S&P 500 has clearly outperformed the high-beta portion over time. But look at the relationship between SPLV and the SPDR S&P 500 ETF (NYSE Arca: SPY). SPY proxies SPLV’s parent index. Sometimes SPLV fares better than SPY and at other times, SPY excels. The run-up to the February 2018 break was, in fact, led by SPY’s outperformance. Muting volatility can sometimes dampen fluctuations on the upside as well as the downside.

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Author: Travis Esquivel

Travis Esquivel is an engineer, passionate soccer player and full-time dad. He enjoys writing about innovation and technology from time to time.

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