Understanding the Low Volatility Factor

This is Part 6 in a series about smart beta ETFs. See below for links to other posts in the series. In this installment, we look at the low volatility anomaly: the surprising idea that stocks with lower risk have tended to outperform.

 

In our introduction to smart beta  a couple of weeks ago, we discussed the capital asset pricing model (CAPM), which is based on the idea that you should expect higher returns from stocks with higher risk. That’s an idea many investors now take for granted, since being rewarded for additional risk makes intuitive sense.

But what if it’s not true?

As early as 1972, Robert Haugen and James Heins found the exact opposite in the data on US stocks between 1926 and 1971. The researchers uncovered a negative relationship between risk and return: high volatility stocks actually tended to deliver lower returns, while low-vol stocks outperformed. In the decades since, many researchers have demonstrated that this low volatility anomaly exists in stock markets around the world, and even in many bond markets.

As with all of the smart beta factors,

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