Low-volatility stocks are behaving precisely as advertised.
That means they’re outperforming the stock market while incurring below-market risk. That’s a winning combination—even if the most hyperactive traders find such stocks exceedingly boring.
The markets aren’t supposed to work this way, of course. We’re taught in Finance 101 that more conservative strategies exact a price for allowing you to sleep more easily at night, and that price is lower returns.
But thanks to pioneering work by the late Robert Haugen, we’ve known at least since the early 1970s that low-volatility stocks don’t adhere to this standard theoretical model. And despite growing attention given to what academicians call this low-volatility anomaly, it persists. This also is surprising, since the usual pattern is for stock market patterns to disappear as more investors discover it and try to exploit it.
I last wrote about low-volatility stocks for Barron’s in February 2018, singling out 10 stocks that at the time were also being recommended highly by at least one of the top-performing newsletters I monitor. Those 10 stocks have indeed been conservative, as measured by their betas. (Beta is a standard risk metric, measuring a stock’s sensitivity to changes in the overall market.) The stocks’ average beta (based on their returns since February 2018) has been 0.61—39% less than the market’s 1.0.
Yet despite being so conservative, those 10 stocks have produced a 21.2% total return, according to FactSet, nearly double the 12.1% of the S&P 500 (.SPX).
Or take the Invesco S&P 500 Low Volatility exchange-traded fund (SPLV). Its beta over the past five years has been 0.72, according to FactSet. Yet over this period it has produced a 12.0% annualized total return, versus 10.8% for the S&P 500.
These results shouldn’t come as a surprise, according to a 2012 study entitled “Low Risk Stocks Outperform Within All Observable Markets of the World,” co-written by Haugen and Nardin Baker, chief strategist at South Street Investment Advisors in Needham, Mass. They compared the returns of the lowest-volatility stocks and highest-volatility stocks in 33 countries’ stock markets between 1990 and 2011, and found that, on average, you would have made far more money by buying the former than the latter. A portfolio that held the 10% of stocks with lowest historical volatility did 18% per year better, on average, than the decile containing the most-volatile stocks.
Not surprisingly, returns like these have garnered a significant amount of attention over the years, especially since they fly in the face of the standard model for how the markets work. And there have been many attempts to explain the low-volatility anomaly away.
One recent attempt was launched in mid-June by Larry Swedroe, chief research officer at Buckingham Strategic Wealth. He argued that “the performance of the low-volatility factor is actually well explained by exposure to other factors.” In layman’s terms, he means that the low-volatility anomaly is really other anomalies in disguise.
The other factors to which Swedroe is referring are those made famous by University of Chicago finance professor (and Nobel laureate) Eugene Fama and Dartmouth College professor Ken French: The well-known tendencies for small-cap stocks to outperform large-caps, for value stocks to outperform growth stocks, for more-profitable firms to outperform less-profitable ones, and so forth.
Swedroe’s argument is flawed, however, Baker told Barron’s. That’s because the lowest-volatility stocks do not have constant exposures over time to the Fama/French factors. That is, sometimes a portfolio of the lowest-volatility stocks will be dominated by, say, small-cap value stocks, and at other times by, say, large-cap growth ones. To replace a low-volatility stock strategy with a portfolio of ETFs that are benchmarked to the Fama/French factors, you’d have to know in advance how those exposures will change going forward.
Good luck with that.
By investing directly in low-volatility stocks, you don’t need to know in advance which sector of the market will be less volatile. “The ingenuity of low volatility is that it automatically avoids stocks that are exposed to areas of increasing uncertainty,” Baker told me. “It is automatically adaptive.”
Note carefully that, as Baker mentioned, the low-volatility strategy is dynamic, dominated at different times by different sectors and investment styles. Currently, the list is dominated by energy stocks. More-diversified bets on the strategy are available with two ETFs: The S&P 500 Low Volatility ETF mentioned above, with an expense ratio of 0.25% (or $25 for every $10,000 invested) and the iShares Edge MSCI Minimum Volatility USA ETF (USMV), with an expense ratio of 0.15%.
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