Low-volatility stocks (those with modest price fluctuations, compared to their brethren) are considered relatively low risk. Nevertheless, theyve outpaced roller-coaster issues for decades. The empirical evidence is clear and has been since the work done by Dr. Robert Haugen in the 1970s, asserts Feifei Li, director and head of research at Newport Beach, California-based Research Affiliates. Writing in her firms Simply Stated publication, Li suggests that investors include a low-volatility component in a diversified portfolio.
Such a recommendation is not merely academic. In recent years, MSCI and S&P have introduced low-volatility indexes. Where there are indexes, it seems, ETFs will follow. PowerShares S&P 500 Low Volatility ETF, for example, which was launched in May 2011, has over $3 billion in assets. Thus, advisors can easily add low-volatility equities to clients portfolios.
As Li shows in her article, low volatility portfolios have produced higher returns with less volatility than traditional large-cap portfolios over the past 5, 10, and 20 years. This phenomenon can be seen in the U.S. and in other developed nations stock markets. During Lis sample period, from mid-1991 to early 2012 (over 20 years), the S&P Low Volatility Index returned 10.2% a year, vs. 8.7% a year for the S&P 500. Among foreign equities, the gap was even larger.
In both the domestic and foreign comparisons, the low volatility stocks were also less volatile, resulting in much higher Sharpe ratios. In addition, Li pointed out, low volatility portfolios have average correlations of 0.40.5 with other major asset classes, whereas traditional large-cap equity strategies have average correlations above 0.6. Reduced correlation may smooth out overall portfolio performance.
Lis data show that low-volatility stocks lagged badly in the dot-com boom of the late 1990s. However, that has not been the case for all bull markets: low-volatility stocks had superior results from 2003 through 2006, when the foreign index returned nearly 30% a year. Altogether, Li concludes that adding low volatility strategies is likely to result in greater diversification and a more attractive final portfolio for investors.