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What is low volatility?
Low volatility can be measured in two ways. The first is standard deviation, which measures the volatility of individual stocks, and the second is beta, which measures the volatility and correlation of a stock relative to the market as a whole. The market has a beta of 1, so a stock with a beta below 1 is considered less volatile than the market, and vice versa for a stock with a beta above 1.
Low volatility is more resilient during contractions
Many managers have adopted this strategy, which consists of beating the markets in contractionary (bearish) phases and not losing too much ground in expansionary (bullish) phases.
Discover the list of "low volatility " stocks
The following illustration shows that although low-volatility stocks tend to underperform market-cap-weighted indices in positive-trend environments, they produce returns comparable to or better than those of market-cap-weighted indices over the long term.
The following illustration shows that from June 1988 to May 2023, the MSCI World Minimum Volatility Index outperformed the market during all six bear market downturns over the 35-year period, illustrating the index's strong defensive characteristics.
Source : MSCI
The following illustration shows that between November 30, 2001 and March 31, 2022, the MSCI World Minimum Volatility index captured 72% of the MSCI World's bullish performance, but only 56% of its bearish performance, almost halving the drawdowns of the benchmark index of developed countries.
Source : MSCI
Low volatility versus minimum volatility
Low volatility investing focuses on the volatility of individual stocks within a benchmark index. Stocks are ranked according to their past volatility measures, and a portfolio is formed accordingly.
It differs slightly from the minimum-volatility approach, which aims to build a low-volatility portfolio as a whole. Indeed, minimum volatility portfolios analyze the volatilities and correlations of the historical returns of all the stocks in the benchmark index. Next, an optimization approach is used to construct the least volatile portfolio possible, taking into account the weights and relationships observed over time.
Low Volatility indices aim to include only low-volatility stocks. Minimum Volatility indices, on the other hand, may include volatile stocks, but it is their overall relationship within the portfolio that is decisive.
Although the methodology between low volatility and minimum volatility indices differs (different in approach but similar in spirit), the results are similar and the conclusions identical: low volatility outperforms in phases of market contraction and high volatility, regardless of geographic region.
Better risk-adjusted performance
It may seem counter-intuitive to many investors, but on a risk-adjusted basis (using the Sharpe ratio), stocks that are less volatile than their counterparts have historically produced comparable returns (or even superior returns over long cycles, such as between 2000 and 2015).
Here are three charts comparing the S&P 500 TR to the S&P 500 Low Volatility TR over three 20-year periods: 1990 to 2010, 2000 to 2020 and 2004 to the present (2024):
- 1990 to 2010: We can see that the lead taken by the S&P 500 during the dot com bubble (1997 to 2000) was subsequently made up during the subsequent deflation of the bubble (2000 to 2003).
Source : Bloomberg
- 2000 to 2020: The end of the dotcom crisis and the financial crisis of 2008 enabled the S&P 500 Low Volatility to outperform its parent index.
Source : Bloomberg
- 2004 to 2024: Despite the lead taken following the 2008 financial crisis, the S&P 500 Low Volatility index has weakened slightly over the past two years relative to its benchmark. The strong presence of more volatile, higher-performing stocks represented in the S&P 500 today (notably technology stocks) explains this difference in performance.
Source : Bloomberg
As you can see, a low-volatility strategy tends to outperform in a bear market and underperform in a bull market, but on a risk-adjusted basis, low-volatility stocks have sometimes been better investments over long cycles, such as between 2000 and 2015. What's more, for an investor, it will be easier to hold a less volatile stock for longer, and as we all know, increasing the time a stock is held increases the probability of a gain.
Discover our low-volatility investment style list
To help you build a defensive portfolio, our team of experts has created a low-volatility investment style list of stocks from around the world with a tendency to low volatility. In this list, you'll find the best-rated low-volatility stocks based on a volatility composite. This list can help you build a portfolio that is less volatile and therefore less risky, but no less effective over the long term.
