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Andrew’s Angle

The Lowdown on Low Vol

Jul 31, 2019

The capacity of factor strategies appears large 

Minimum volatility, or low volatility, strategies do just as their name suggests: they seek to lower portfolio volatility, and this tends to help portfolios be resilient in periods of high market uncertainty. But counterintuitively this year, minimum volatility strategies have also done well as the market has rallied. How is this possible? To answer, let’s dig into the behavior behind this well-known factor.

There’s a secret to successful investing: minimize the downside.

Example
Negative returns really bite on the downside. I used to be a professor—and now I ask you to indulge me as we work through an example.

Suppose the market goes up by 50% and then falls by 50%. You haven’t broken even – you end up down by -25%:

Figure 1: Negative returns bite

Figure 1: Negative returns bite

Source: BlackRock, for illustrative purposes only.

If you can cut out some of the volatility, then you’re more likely, over the long run, to grow your wealth. This is exactly what minimum volatility strategies are designed to do.

Now suppose we have a gain of 25% and a loss of 25%. In reality, minimum volatility strategies have reduced more risk on the downside than they have on the upside, but let’s keep things simple. Note that we have the same average return, of 0% as the first example.*** Then we obtain the following pattern.

Figure 2: Losing less can pay off

Figure 2: Losing less can pay off

Source: BlackRock, for illustrative purposes only.

We’ve cut our loss from -25% to -6.25%, just by losing less.

Higher risk may = lower reward

This is not just academic.

In 2006, I published “The Cross‐Section of Volatility and Expected Returns with professors Robert Hodrick, Yuhang Xing, and Xiaoyang Zhang, in the Journal of Finance. In the paper, we brought attention to the counterintuitive finding to academics and practitioners of the low risk anomaly: that more volatile stocks tend to have lower returns. In fact, we stated that stocks with the highest volatilities exhibited “abysmally low” returns. Stocks with low volatilities tended to have returns which were approximately the same as the market.

Here’s an illustration, of this effect, using data from my original paper:

Figure 3: High vol stocks have had "abysmally" low returns

Figure 3: High vol stocks have had "abysmally" low returns

Returns of stocks are gross of fees and transaction costs, which will have lower returns. Past performance is not a guarantee of future results.
Source: Table VI from paper Ang, Andrew, Robert J. Hodrick, Yuhang Xing and Xiaoyan Zhang. "The Cross-Section Of Volatility and Expected Returns," Journal of Finance, 2006, v61(1,Feb), 259-299. Sample period is July 1963 to December 2000. “Low Risk, 2, 3, 4, and High Risk” labels for the x-axis in the chart represent quintiles, where Low Risk is the bottom quintile and High Risk is the top quintile. Risk is based on idiosyncratic volatility. The universe is CRSP stock data. CRSP stock data includes data from NYSE, NYSE American, NASDAQ, and NYSE Arca stock exchanges. Idiosyncratic Volatility refers to the specific risk of a security, after removing market risk.

Why has there been a low vol premia?

There are two key economic rationales for why the low volatility anomaly exists:

  1. Structural impediments prohibit the use of leverage, or result in restrictive investment policies, by many institutional investors. At the same time, these investors have high total return targets, so they have tended to overweight high-volatility stocks in the hopes of hitting these return objectives. The knock-on effect has been prices for higher volatility stocks tend to be pushed up, leaving lower volatility stocks underpriced.
  1. Investor behavior is not perfectly rational all the time. One behavioral bias that tends to afflict investors is the lottery effect. (A personal confession: I do occasionally buy lottery tickets!) Investors tend to chase flashy, riskier stocks, believing that the probability of winning is high, even if the odds are stacked against them. This behavior can bid up the price of high-risk names, leaving lower risk securities overlooked and often underpriced.

Minimum volatility strategies seek to capitalize on both of these well-known tendencies. Low volatility funds have historically experienced returns that have provided much of the upside of the overall market over the long run—but with reduced risk (as measured by standard deviation).1

It has worked even better in practice

In our theoretical example, risk was symmetric. In reality, the reduction in risk (as measured by standard deviation, or the potential the range of outcomes)1 has been even greater in downside risk—where risk really bites.

Since 2011, iShares Edge Minimum Volatility ETFs have demonstrated this ability to lose less during market declines and capture a significant portion of the upside as markets rally, as illustrated in Figure 4 below.

Figure 4: Upside/downside capture

Figure 4: Upside/downside capture

Source: Morningstar, as of 06/30/19. Based on fund and index returns from 11/1/11 – 06/30/19 (funds incepted 10/18/2011). Data compares USMV to the S&P 500, EFAV to the MSCI EAFE Index, EEMV to the MSCI Emerging Markets Index, and ACWV to the MSCI ACWI Index. Performance data represents past performance and does not guarantee future results. Investment return and principal value will fluctuate with market conditions and may be lower or higher when you sell your shares. Current performance may differ from the performance shown. For most recent month-end performance and standardized performance, click here. Index returns are for illustrative purposes only and do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged, and one cannot invest directly in an index.

What’s the answer?

So, why are minimum volatility strategies keeping up with the market so far in 2019?

Markets are up, but it hasn’t been a straight path up. And when markets have fallen, as they did in May 2019, minimum volatility has fallen less—and that reduced volatility has led to long-term increases in returns. A trend we highlighted in our latest Factor Outlook.

Figure 5: Growth of Hypothetical $1 Invested YTD

Figure 5: Growth of Hypothetical $1 Invested YTD

Source: MorningStar, as of 6/30/2019. Based on fund and index returns from 12/31/18 – 06/30/19. Data compares USMV to the S&P 500 Index. The Hypothetical Growth of $1 chart reflects a hypothetical $1 investment and assumes reinvestment of dividends and capital gains. Fund expenses, including management fees and other expenses were deducted. Performance data represents past performance and does not guarantee future results. Investment return and principal value will fluctuate with market conditions and may be lower or higher when you sell your shares. Current performance may differ from the performance shown. For most recent month-end performance and standardized performance, click here. Index returns are for illustrative purposes only and do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged, and one cannot invest directly in an index.

Low volatility has delivered what it’s supposed to—participate in the majority of market upside periods and minimize its participation in market downside.

It’s not only 2019. In the 40 largest monthly drawdowns since the iShares Edge MSCI Min Vol USA ETF inception (October 2011), the fund has outperformed the market (as defined by the S&P 500 Index) 31 times with an average excess return of 1.5%.2 Over the 10 worst market drawdowns since the iShares Edge MSCI Min Vol USA ETF’s inception, the fund has outperformed over all of them with an average excess return of 4.0%.3

Theory and practice

There’s nothing more satisfying to me than seeing theory and practice work together, practice confirm theoretical studies, and theory advancing how we can bring the benefits of investment insights to everyday investors. This is the case for minimum volatility.

It’s no surprise min vol has attracted many followers, with over USD 5.8 billion in inflows into the iShares Edge MSCI Min Vol USA ETF alone over the first six months of 2019.4 Think twice before selling when equities fall, which can affect the potential long-term rewards of equity securities. We can invest in equities in a risk-managed way. Minimum volatilities show us how.

*** Those astute, technical readers will note that while the expected arithmetic return is constant, lower volatility reduces the geometric return—which is the key to growing long-term wealth.

Andrew Ang
Head of Factor Investing Strategies
Andrew Ang, PhD, Managing Director, coordinates BlackRock’s efforts in factor investing. He leads BlackRock’s Factor-Based Strategies Group which manages macro and style ...