Low Volatility and Defensive Factors

Finance theory says higher risk should bring higher expected return. Yet research has repeatedly found that stocks with low volatility or low beta have delivered returns similar to or better than high volatility stocks, with much less risk. This low volatility anomaly is one of the most puzzling patterns in finance and the basis for popular "minimum volatility" and "low beta" funds. Understanding why it might exist, and when it struggles, helps investors use it sensibly.

The evidence#

• Black, Jensen and Scholes (1972) and later Haugen and Heine (1975) found that the relationship between beta and return was much flatter than the capital asset pricing model predicted.
• Ang, Hodrick, Xing and Zhang (2006) found that stocks with high idiosyncratic volatility had very low subsequent returns.
• Frazzini and Pedersen (2014), in "Betting Against Beta", found that portfolios long low beta assets and short high beta assets (leveraged to equal risk) earned positive risk adjusted returns across many markets and asset classes.

Measuring low volatility#

Why might it exist?#

When low volatility struggles#

• Strong rallies: low beta stocks lag when markets surge, as in 2003 or the 2020 rebound.
• Rising interest rates: low volatility portfolios often hold bond like stocks such as utilities and consumer staples, which can fall when rates rise sharply, as in 2022's early months. See Interest Rates.
• Expensive valuations: popularity can push low volatility stocks to high prices, reducing future returns. See Factor Timing, Crowding and Crashes.
• Sector concentration in a few defensive industries.

Relationship with other factors#

Low volatility overlaps with quality: stable, profitable companies tend to be less volatile. Some research finds profitability explains part of the low volatility effect. It also tends to have negative exposure to size and momentum at times. See Quality and Profitability Factors.

Implementing low volatility#

Frequently asked questions#

What is the low volatility anomaly?#

The finding that low volatility or low beta stocks have delivered similar or better returns than high volatility stocks with less risk, contrary to standard theory.

Why do low volatility stocks perform well?#

Possible reasons include leverage constraints, investors overpaying for lottery like volatile stocks and benchmark pressures on fund managers.

When does the low volatility factor underperform?#

During strong market rallies and periods of sharply rising interest rates, and when low volatility stocks become expensive.

Next, learn the factor that earns from yield differences in Carry Factor.