In last year´s blog post “A strategy for All Weathers” I mention that there are various ways in which to invest the portion of your portfolio that is allocated to equities. One of the more interesting factors is to bet on the “Low volatility Anomaly”.

Low anomaly what?

Ok, let´s start from the beginning. As we have already seen, in classical financial theory there is a a positive relationship between the Beta or the volatility (the beta is composed of the volatility of the stock, the volatility of the market and the correlation between market and security) of a stock and its expected return. As the beta of the stock increases we expect to be remunerated with increasing higher returns for this higher larger amount of risk.

What the low volatility anomaly shows empirically though, is that low risk stocks measured by low volatility or low beta tend to outperform their riskier counterparts. In fact it shows that:

- There is an inverse relationship between volatility and future returns
- There is an inverse relationship between beta and future returns
- Portfolios made of minimum variance stocks fare better than the market

This seems very counter intuitive and almost like an arbitrage opportunity. How could a portfolio which is less risky do better than a risky aggregate index? But as we see below, the sharp ratio continuously decreases with increasing risk.

There are different ways to take advantage of the low volatility anomaly.

Let us construct factor mimicking portfolios consisting of a long position in the less volatile securities and a short position in the volatile ones. We can do this based on realized volatility or realized beta. The portfolios are constructed as follows.

Based on realized beta we construct the “Betting Against Beta” portfolio.

The BAB portfolio scales its position in low volatile stocks up by their beta and scales down the position in risky stocks according to their respective beta. Similarly, a portfolio based on low volatility can be constructed as follows:

As in the BAB case the weights are scaled up and down according to realized volatility and the portfolio is scaled to a target volatility (sigma – target).

So, how do these portfolios perform? Extraordinarily! See yourself!

**Possible explanations**

- Data Mining: The results may simply be subject to the search for “some” anomaly. If one searches long enough one is sure to find something. This however seems unlikely. Even though the results are sensitive to some portfolio weightings the anomaly can be detected in international equities, US equities, bonds, derivatives and FX.
- Constrained Leverage: Even though financial theory assumes that everybody can borrow unlimited financial capital seeking to lever his investments, this may not be applicable in reality. Thus, people want to invest in securities that contain a “built-in” leverage. High volatility and high beta stocks facilitate this. Since more people want to invest in these levered investments, prices increase and expected return decreases
- Constraints: Some institutions may not be able to invest in the low volatility anomaly due to regulatory constraints. Given their weight in the market this allows for the mispricings to occur.

There are many exchange traded funds allowing to invest in this anomaly. Below you see the multi-year performance of BlackRock´s “iShares Edge MSCI Min Vol USA ETF”. We see a slow but steady uptrend. With a management fee of only 0.15% it is a cheap way to play this anomaly for any investor confident about the prospects of stocks with low volatility.

If this is an investment for you is something I cannot foresee. As any other investment strategy this strategy is not without its risks but rather bets on stocks that have been less volatile in the past.

Best,

Nils