Understanding the Low-Volatility Factor
When you are driving from one city to another, you might come across various twists and turns. Similarly, in your journey of wealth creation through investing in equity, you might come across many twists and turns which we can call volatility.
Volatility refers to the fluctuations or ups and downs of a financial asset, such as a stock, bond, or currency. In layman's terms, it is a measure of how much the value of an investment changes over time. A higher volatility means the value of an investment can change rapidly and unpredictably, which also means a higher volatility in returns. A lower volatility means the value changes less often and is more steady. The returns consequently are also steadier.
Everyone is familiar with the tale of the rabbit and turtle race. Low volatility can be compared to a turtle in a race against a rabbit. Just like a turtle takes its time and steadily moves toward the finish line, a low-volatility investment strategy delivers consistent returns over time, without taking on too much risk. On the other hand, the rabbit may run faster and achieve quick gains in the short-term, but is more likely to tire out and make mistakes, leading to volatile and inconsistent returns. In this analogy, the turtle represents a low-volatility strategy that wins the race with consistent, long-term performance. Investing in low-volatility factors can be described as a strategy of defensive investing wherein the investors can minimize risks while getting similar, possibly superior returns.
A low-volatility portfolio consists of equities that are generally less volatile than their peers which, however, have the tendency to generate alpha. When the markets are in periods of high volatility, investors generally tend to find a safe haven to park their funds. At these times, low-volatility factor investing has proved to be a safe and consistent investment strategy. In periods of economic downturns or bear markets, low-volatility stocks may fall less and due to this, they have the potential to provide better returns over a longer period of time. Hence, the low-volatility strategy also supports the theory - “a lower fall is equal to a higher return.
It is generally believed, taking on more risk would mean a higher return. The low-volatility anomaly refers to the phenomenon in which less volatile stocks outperform more volatile stocks. A study conducted by professors from Zurich University and VU University Amsterdam (Merz & Janus, 2016), tests a period of 15 years spanning from 2000 to 2015, a period during which the tech bubble burst, the market rallied, the great financial crisis of 2008 and post-crisis recovery took place. Their study indicates that during strong market corrections, the low-volatility factor produced excess returns between 5.6% and 17.2% for US equities and between 1.8% and 16.7% for European equities. (Merz & Janus, 2016)
Thus, the existence of the low volatility anomaly, makes investing in less volatile stocks more profitable over a longer period of time.
“The low volatility anomaly is one of the most robust and persistent market anomalies, and provides a rare opportunity for investors to improve their returns and reduce their risk at the same time. - Pim van Vliet
NJ’s Factor Book data suggests that the 5-year and 10-year rolling returns of Nifty 500 TRI are 14.47% and 13.42% respectively as compared to the low-volatility factor’s 5-year and 10-year rolling returns of 16.96% and 16.89% respectively.
Source: Internal research, Bloomberg, CMIE, National Stock Exchange of India
- CAGRs are calculated as the average CAGR based on the rolling CAGRs (rolled daily) calculated for the respective holding periods i.e. 5 and 10-Yr rolling CAGRs.
- The period for calculation is 30 September 2002 to 31 December 2022. Data scaled to 1000 on 30th September 2002.
- Past performance may or may not be sustained in the future and is not an indication of future return.
- NJ Low Volatility 100 Portfolio is a proprietary methodology developed by NJ Asset Management Private Limited. The methodology will keep evolving with new insight based on the ongoing research and will be updated accordingly from time to time.
Recovering from losses:
Recovering from losses is easier in the case of less volatile stocks as compared to more volatile stocks. This is because when a small loss is incurred, it takes a bigger gain to just bounce back to the original level, let alone earn gains. This gap increases with the scale of the loss. For instance, a loss of 10% will require a gain of 11.11% to return to its original value but a loss of 50% will require a gain of 100% to do the same.
Hence, lower the volatility, lower the losses will be and easier would it be to get even.
Low-volatility factor in performance - S&P Dow Jones
As factor-based investing has gained popularity in developed nations, low-volatility has emerged as an important factor. S&P Dow Jones Indices tested the returns of S&P 500 low-volatility against S&P 500 over a period of 10 years to check whether they live up to the backtested performance. It was concluded that the low-volatility factor performed upto expectation by attenuating to the market’s returns in both directions (S&P Dow Jones Indices, 2021). The 5-year and 10-year rolling returns of S&P low-volatility index are 9.82% and 9.67% as opposed to 5-year and 10-year rolling returns of S&P 500 index - 8.09% and 7.68% respectively. The chart below shows the performance of the low volatility factor.
Source: S&P Dow Jones Indices LLC
- CAGRs are calculated as the average CAGR based on the rolling CAGRs (rolled daily) calculated for the respective holding periods i.e. 5, and 10-Yr rolling CAGRs.
- The period for calculation is 5 July 1995 to 31 December 2022. Data scaled to 1000 on 5 July 1995.
- Past performance may or may not be sustained in the future and is not an indication of future return
- Merz, T. and Janus, P. (2016) Low-volatility investing: Empirical evidence of the defensive properties of low volatility enhanced portfolios, SSRN. Available at: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2801534 (Accessed: February 13, 2023).
- S&P Dow Jones Indices (2021) Low volatility and high beta: A study in Backtest integrity, S&P Dow Jones Indices. Available at: https://www.spglobal.com/spdji/en/research/article/low-volatility-and-high-beta-a-study-in-backtest-integrity/ (Accessed: February 14, 2023).
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