Introducing Volatility Factor Investing
We introduced the momentum factor in our earlier post "Introducing Momentum Factor Investing". Let's turn our attention now to the other factor that our strategies tend to tilt toward - the volatility factor. More specifically, our tendency to target low volatility.
What Is Low Volatility?
In simple terms, low volatility can be associated with minimal price fluctuations. Hence, a stock with low volatility can be expected to stay within a narrow price range. However, note that this is not permanent and can change if the stock goes through a fundamental change or is affected by bad news. Low volatility characteristics tend to be more persistent when referring to a broad-based underlying like stock sectors or indices due to diversification.
We can generally say that low volatility is associated with greater certainty in terms of future outcomes. For example, if XLU which is the utilities sector ETF is currently trading at $65, there is a high chance that it will still be trading within a range of $60-$70 in one year.
High Risk, High Return?
When we invest, we want to make as much profit as possible and quickly. This is why many tend to gravitate towards stocks or securities with high volatility. Stocks that do not move are seen as boring and not able to deliver life-changing profits. There is a general notion that high returns can only be achieved with high risk. While this might be true if you are only looking for quick profits, research has shown that the opposite is true over the long run.
The chart above illustrates the reason why volatility is associated with certainty. When volatility is low, returns tend to cluster around the same region. When volatility is high, returns are all over the place. It can be a windfall or it can be a huge loss. The greater the volatility, the more it resembles a toss of the dice. Hence, if you want a more certain investing outcome, it is better to target low volatility.
How Do Institutions Harvest Low Volatility?
There are generally two approaches that institutions use to take advantage of this factor. The first approach is to use a simple rank and selection. The securities under consideration are ranked in order of either their historical or expected volatility. The securities are then sorted into any number of equal parts such as quartiles. Securities in the quartile with the lowest volatility are chosen to be included in the portfolio and held for some time. The exercise is then repeated at the end of the period.
The second approach is to use optimization-based solutions on a basket of securities. This approach takes into account the correlation between the securities within the basket and optimizes for the lowest portfolio volatility. The solution would give the target allocation weights for the securities in the basket. The securities can all be stocks or they can be different asset classes as well.
How Strong Is The Volatility Factor?
The volatility factor is not the strongest return generator among all the investing factors although it is still able to generate excess returns above the benchmark buy and hold over the long run. This is to be expected as the focus of the volatility factor is not to target high returns.
However, the volatility factor shines when it comes to stability. It delivers one of the highest risk-adjusted returns among all the investing factors. In other words, it can generate the most return for the least amount of risk taken.
What Are The Pitfalls Of Targeting Low Volatility?
Certain stock sectors, asset classes, and even countries tend to exhibit low volatility. Hence, if we blindly target low volatility all the time in the case of the rank and selection approach, we would end up holding the same underlying securities most of the time. This might expose us to unwanted risk factors and may lead to suboptimal diversification.
For optimization-based solutions, the allocation that gives the lowest portfolio volatility may not necessarily be the best when considering other investing factors as well.
How To Mitigate The Pitfalls?
Some mitigating approaches include but are not limited to the following:
1) Classify the investment universe into buckets before applying the rank and selection process. For example, you can have a bucket for cyclical stocks and another for defensive stocks. You then rank the cyclical stocks and select the less volatile ones for inclusion. You do the same for the defensive stocks. In this way, you make sure you have representation from both buckets in your portfolio.
2) Apply constraints for optimization-based solutions so that low portfolio volatility is not the only optimization objective. For example, you can set equal risk contribution as one of the constraints while you optimize for the lowest portfolio volatility. This by the way is the risk parity approach that we teach in our course.
The volatility investing factor is not meant to target high returns but it targets stability in the form of low volatility. This leads to better risk-adjusted returns in the long run. However, the naive approach of blindly targeting low volatility can lead to concentration risk and suboptimal asset allocation. However, there are some mitigating solutions to avoid these pitfalls.
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