Steady Profits: Exploring the Low Volatility Anomaly in Stock Investing
Quick Tips
- Our Youtube Channel
Brother Dog’s Finance — YouTube
- Quandamental (Fundamental + Quantitative) Stock Scoring (Updated daily and cover SPX, NASDAQ, RUSSELL 1000/2000)
Highlights & Takeaways
- Return volatility anomaly refers to a phenomenon in financial markets where stocks with lower historical volatility tend to outperform stocks with higher historical volatility. This anomaly contradicts the traditional assumption that higher returns should be accompanied by higher levels of risk or volatility.
- Our study has validated the existence and significance of the low volatility anomaly across a broader range of US markets, including the SP 500, Russell 1000, and Russell 2000. The findings demonstrate that stocks with higher volatility consistently underperform those with lower volatility in terms of both absolute and risk-adjusted returns. Furthermore, the higher volatility stocks exhibit higher risk metrics such as maximum drawdown and return volatility.
- Specifically, over the past two decades, stocks with the lowest return volatility (measured over a 6-month period) have consistently outperformed their high-volatility counterparts. Under the SP 500, Russell 1000, and Russell 2000 universes, these low-volatility stocks have delivered approximately 10%, 15%, and 20% higher annual returns, respectively, from a risk-adjusted return perspective.
- It is important to emphasize that to effectively capture the benefits of the low volatility anomaly, investors must properly hedge the beta components of stocks. This is because the high-volatility stocks typically possess higher market beta components, causing them to rally more significantly during periods of strong market upswings.
- In conclusion, we consider the low volatility anomaly to be a reliable, robust, and consistent alpha generator in the future. We highly recommend incorporating this factor into investment portfolios to achieve a better return-risk profile. By strategically including low-volatility stocks and appropriately hedging beta components, investors can potentially enhance their overall investment outcomes.
Introduction & Intuition
The return volatility anomaly challenges the efficient market hypothesis, which suggests that prices in financial markets fully reflect all available information. According to this anomaly, investors could potentially achieve higher risk-adjusted returns by investing in stocks with lower historical volatility.
In this section, we will examine the above argument from a quantitative perspective, using stock trailing 6 month return volatility.
Factor Study Framework
We will analyze the performance of stocks with higher return volatility (6 month) compared to those with lower return volatility (6 month) during the period of January 2000 to March 2023, using the following framework to determine which group delivers better returns.
Return Volatility (6 Month) Factor in SP 500
The following results (Jan 2000 — Mar 2023) are displayed.
- Quintile Annualized Returns (both total return and alpha return).
- Quintile Long-Short Cumulative Returns, where the best quintile (Q5) is long and the worst quintile (Q1) is short.
1. Quintile Annualized Returns
Just as a reminder, we use two types of return measures in our analysis. Total return measures the overall return from the stock, which includes both the market return and the stock selection return. On the other hand, alpha return focuses solely on the stock selection return by removing the market return component from the stock return. This distinction will allow us to evaluate the effectiveness of the return volatility (6 month) factor more precisely.
Details on two return components can be found:
Quintile Analytics
Observations:
- Over the past two decades, a clear pattern has emerged in the SP 500 that supports the existence of the “low volatility anomaly.” This anomaly is characterized by stocks with the highest 6-month return volatility exhibiting the lowest returns and the highest risk metrics, including maximum drawdown and Sharpe ratio. Conversely, stocks with the lowest volatility demonstrate the highest return profiles.
- The presence of the low volatility anomaly in the SP 500 provides strong evidence that investors can achieve favorable risk-adjusted returns by focusing on stocks with lower volatility. These stocks not only deliver higher returns but also exhibit lower risk metrics, indicating better risk management and stability.
2. Quintile Long-Short Cumulative Returns
Long-Short (Q5 — Q1) Return Analytics (Monthly)
Observations:
- The monthly average risk-adjusted return difference between stocks with the highest return volatility and lowest return volatility is 0.8%. This difference is not only statistically significant but also implies an attractive and stable return potential over time. Importantly, this potential exists across various market conditions, including both upward and downward movements.
- Meanwhile, stocks with the highest return volatility tend to have higher beta, indicating a stronger correlation with market movements. Consequently, when the market is experiencing an upward trend or a recovery phase, these high-volatility stocks may rally more significantly. This highlights the importance of properly hedging the stock beta component when seeking to capitalize on the low volatility anomaly.
Return Volatility (6 Month) Factor in Russell 1000 and Russell 2000
It is worth noting that the S&P 500 index consists of the 500 largest and most actively traded companies in the US, where stocks are generally priced more efficiently than in other stock universes.
To determine whether our conclusions hold true in different stock universes, we extended our study to include the Russell 1000 and Russell 2000 universes. This expansion allowed us to compare the performance of stocks with higher return volatility (6 month) to those with lower return volatility (6 month) under different market conditions and environments.
- Quintile Annualized Returns
2. Quintile Long-Short Cumulative Returns
Observations:
- The presence of the low volatility anomaly extends beyond the SP 500 and encompasses the Russell 1000 and Russell 2000 universes as well. This indicates that the phenomenon is not limited to specific market segments but exists across the broader stock market.
- In addition, what we observed in these universes is that the strength of the low volatility anomaly is even more pronounced, further emphasizing its significance for investors. Stocks with lower volatility consistently exhibit higher risk-adjusted returns compared to those with higher volatility.
Notes:
- All data in the analysis are sourced from Yahoo Finance & Financial Modeling Prep.
- Past performance is no guarantee for future investment results.
