The Valuation of Low Volatility

Low volatility strategies typically perform well when markets decline. They have been popular in recent years and some claim they are overvalued. It is possible to identify environments when low volatility strategies offer more bang for the buck?

Introduction

What is commonly referred to as the low volatility anomaly is not a recent discovery; it has been well documented in academic research for over four decades. Popularized in the turmoil following the 2008 financial crisis, low volatility strategies, as the name suggests, have served well in times of market distress. The anomalous aspect is that despite their lower risk, low volatility strategies have outperformed their benchmarks over time, challenging classic capital asset pricing theory that risk and reward go hand in hand.  The long-term outperformance of low-risk portfolios is perhaps the greatest anomaly in finance.

The S&P 500 Low Volatility Index is one example of such a strategy. From January 1991 to December 2019, this index delivered an average annual return of 11.28%, compared with 10.44% for the S&P 500, with less volatility (standard deviations of 11% and 14%, respectively). This same risk/return profile is consistent with history extending to the 1970s.

In recent years, low volatility strategies have gained fortune along with fame, gathering about $130 billion in assets in more than 200 funds globally. Along with the generous inflows, concerns have risen around the valuation of the portfolios tracking low volatility strategies.