The low volatility anomaly in the spotlight

The low volatility anomaly is getting some serious press these days. Historically that has not always been a good sign for future performance. So what does it mean for the future performance of low vol strategies?

We are no strangers to the low vol anomaly here at Abnormal Returns. We noted it in our book Abnormal Returns: Winning Strategies from the Frontlines of the Investment Blogosphere. We have also published posts along the way on the topic as well, including a two-part Q&A with Nardin Baker (part one & two). We have also noted the recent publication of Eric Falkenstein’s new book The Missing Risk Premium: Why Low Volatility Investing Works.

In an article at Institutional Investor, Adrian Banner, Vassilios Papathanakos and Phillip Whitman look at the surge in popularity in low volatility investment strategies and take a closer look at the dynamics behind the performance of these portfolios. One important point they make is that the low vol anomaly is more than the idea that stocks with low volatility outperform stocks with high volatility. The construction and rebalancing of low vol portfolios plays a role in their performance. They write:

The anomaly can be better understood by considering portfolio-level effects. This may seem a little counterintuitive. After all, if portfolios consisting of low-volatility stocks perform so well over the long term, doesn’t this mean that the low-volatility stocks must themselves generally perform well? Not necessarily. Compounding and rebalancing effects complicate the picture. To continue to hold low-volatility stocks within a given investable universe without style drift, an investor must periodically sell stocks that have increased in volatility or fallen out of the universe. Applied diligently, this requirement becomes a rebalancing rule for portfolio construction. The difficulty in understanding what drives the performance of the resulting portfolio is that the rebalancing itself contributes to the portfolio return substantially.

Banner, et al. go to discuss the importance of lowering volatility on portfolios and why the low vol anomaly should persist over time. Throughout the history of investing analysts have promoted various strategies as having the potential to beat the market on a sustained basis. In most cases, these claims have been fleeting or entirely unfounded. It therefore behooves those investors who have poured money into funds like the popular S&P 500 Low Volatility Index ETF ($SPLV) to better understand the dynamics behind the performance of these strategies.

Update: Eric Falkenstein at Falkenblog skeptically weighs in the Banner et al. explanation of the low volatility anomaly.

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