Low-Volatility Cycles: The Influence of Valuation and Momentum on Low-Volatility Portfolios

Research showing that the lowest-risk stocks tend to outperform the highest-risk stocks over time has led to rapid growth in so-called low-risk equity investing in recent years. The authors examined the performance of both the low-risk strategy previously considered in the literature and a beta-neutral low-risk strategy that is more relevant in practice. They found that the historical performance of low-risk investing, like that of any quantitative investment strategy, is time varying. They also found that both low-risk strategies exhibit dynamic exposure to the well-known value, size, and momentum factors and appear to be influenced by the overall economic environment. Their results suggest that time variation in the performance of low-risk strategies is probably influenced by the approach to constructing the low-risk portfolio strategy and by the market environment and associated valuation premiums. We have extended prior research on the low-volatility anomaly by examining the time-varying performance of, and the influence of well-known investment factors on, the low-risk strategy. We have done so primarily by reporting a strong dynamic link between the performance of low-volatility strategies and initial valuations—investigating the performance of both a zero-cost and a beta-neutral low-volatility strategy—and by reporting an important connection between the strategy and both economic activity and momentum. In putting together our study’s findings, an interesting picture has emerged. Low-risk stocks tend to outperform high-risk stocks but are most likely to do so when initial valuation levels favor low-risk stocks. Thus, investment success seems to depend importantly on the price paid. In addition, once the well-known cross-sectional factors of style and momentum are controlled for, alphas and information ratios for our two long–short portfolio strategies decline. We have also shown that there have been extended periods over the last 85 years when high-risk stocks have cumulatively outperformed low-risk stocks. These periods have tended to coincide, to some degree, with economic cycles. The practical implication of our results is that the performance of low-risk strategies is influenced by the approach to constructing the low-risk portfolio strategy and by time-varying exposure to the market environment and valuation premiums. Investors can benefit from a fuller understanding of how these factors may influence future performance of low-risk portfolio strategies. Editor’s note: Rodney N. Sullivan, CFA, was the editor and Luis Garcia-Feijóo, CFA, CIPM, was an associate editor of the Financial Analysts Journal at the time this article was submitted. Mr. Sullivan and Dr. Garcia-Feijóo were both recused from the peer-review and acceptance processes, and the reviewers were unaware of their identities. In addition, they are ineligible to receive any award. The article was accepted in August 2014; it is published in this issue to abide with the FAJ conflict-of-interest policies then in place, which stipulated that, should the paper be accepted, the editor is allowed to publish one research article or Perspectives piece per calendar year. For information about the current conflict-of-interest policies, see www.cfapubs. org/page/faj/policies. The authors may have a commercial interest in the topics discussed in this article.