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Can Low Volatility Strategies Support Diversification?

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Can Low Volatility Strategies Support Diversification? PART 1 OF 1

Can Low Volatility Strategies Support Diversification?

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Low volatility investment strategies don’t need high levels of market volatility to do well.

Market volatility tends to cluster: it can be subdued and then burst higher. That’s why the common practice of comparing the market’s current level of volatility to a historical average can be very misleading for investors. After all, a person with one hand in ice water and the other in boiling water isn’t comfortable, even if the average water temperature between the two pots is room temperature. In terms of market volatility—sure you can calculate an average—but just because you can calculate it, that doesn’t mean the average is going to be meaningful or useful.

So where does volatility stand, today, and where does it originate from? Whether investors look at implied volatility as measured by the Chicago Board Options Exchange Volatility Index (CBOE VIX), or realized stock market volatility, there’s no denying that stock market volatility has hit historic lows.

A variety of forces can drive security returns. When you assemble individual securities into well-diversified collections, like asset classes, the fundamental forces tend to narrow down to a select few macroeconomic drivers such as:

  • Economic growth
  • Real yields
  • Inflation
  • Sentiment

In order for market volatility to happen, volatility must be occurring in one of those macroeconomic drivers. Certainly, we’ve seen developments like moderating inflation, low real interest rates, and slow economic growth—but still, growth has been relatively steady. Macroeconomic data has been stable, and overall, we’re experiencing a very slow, but relatively stable, U.S. economic expansion.

Whether the near future will look like the near past, in terms of macro stability, is anyone’s guess. That’s why long-term investors typically diversify across a number of different asset classes, balancing their risk exposure to these macro drivers. If the macro backdrop stays stable, then market volatility can stay low. See how macro and market volatility have corresponded over time, in the following chart.

Can Low Volatility Strategies Support Diversification?

Index definitions

However, things can change, and that’s one of the appeals of low volatility strategies.

Low volatility investment strategies invest in securities whose returns over the recent past have been more stable than the broader market. This is not because low volatility securities have historically higher returns than higher volatility securities do; it is because they tend to deliver comparable returns with significantly less variability in returns.

In investing, people generally expect that more risk equates to higher returns. However, as Harindra De Silva and Roger Clarke of Analytic Investors showed in a 2010 article published in the Journal of Portfolio Management, there’s a peculiarity in the historical record: Over long periods of time, higher volatility stocks have not tended to earn an extra return, compared with more stable stocks. This result should raise the question in investors’ minds about whether it pays to take on the extra risk of higher-volatility stocks—it can in certain environments, but not necessarily over long time periods. Higher volatility strategies can play an important role as part of a well-diversified portfolio, but diversifying across the entire spectrum of volatility exposure levels can also be important.

Can Low Volatility Strategies Support Diversification?

Index definitions

Clarke and de Silva’s research also showed that volatile stocks tend to do better when the broad market is advancing, or when small cap stocks are doing well. Also, low volatility strategies do not need high market volatility to do well. Sometimes they just need changing volatility.

As the middle example in the above chart shows, low volatility strategies can have a difficult time keeping up with a sharply rising market with little volatility. This might be because many low volatility stocks tend to be a bit more “defensive,” in the following ways:

  • They have a history of holding up better in market sell-offs
  • They tend to have relatively steady earnings
  • They tend not to be momentum stocks

However, if market conditions change, or the macroeconomic backdrop alters, low volatility strategies may offer nice diversification properties for investors, as part of a portfolio that’s designed to meet their goals, risk tolerance, and time horizon. In this scenario, imagine if there’s suddenly an economic hiccup in which economic growth sputters. That macroeconomic volatility, even through a small increase in volatility, can amplify into short—and perhaps limited—increases in market volatility. In this case, a low-volatility strategy could outperform, as the broader market tries to find its footing. The result in that scenario would likely be a portfolio that historically has outperformed when the broader market advanced, at a moderate pace, and still participates when the market rallies. The real benefit may be to win by not losing as much, in the event that the broader market does indeed sell-off.

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