With the equities markets experiencing one of their worst stumbles in years, exchange traded fund investors may turn to low-volatility strategies that could help hedge the risks and diminish a portfolio’s swings.
“Low volatility is one of the few factors that have historically performed well in turbulent markets,” according to a MSCI research note, Constructing Low Volatility Strategies. “Moreover, over long periods of time, this defensive strategy has produced a premium over the market, contravening one of the most basic theories in finance — that one should not be rewarded with greater returns for taking less than market risk.”
Extensive research has gone over the so-called low-volatility anomaly. As a more conservative strategy, low-volatility investments are expected to provide investors with smaller swings and more boring returns. However, the strategy has historically outperformed with higher risk-adjusted returns.
“Mostly behavioral arguments have been offered to explain the low volatility premium,” MSCI said.
Behavioral characteristics include the lottery effect where investors bet on a win in high volatile stocks; representativeness or the tendency to overpay for “glamorous” high volatility stocks; overconfidence in one’s ability to forecast the future; agency issue where people tend to eschew low-vol stocks due to less research; and asymmetric behaviors where low-vol stocks show smaller swings in both down and up markets.
MSCI utilizes a sort of optimized-based method, which accounts for volatility and correlation effects, as opposed to simpler methods that rank components based on levels of volatility.
“Optimization-based approaches provide a more flexible framework to incorporate different types of constraints,” MSCI said. “Moreover, only optimization-based approaches can take full advantage of the correlation between stocks, a key component in designing a low volatility strategy.”