Why “Low Volatility” Funds Were Volatile During the Covid 19 Crash

Low Volatility is what’s called a “quantitative” strategy. It looks at the numbers, basically. This is the opposite of a “qualitative” style that looks at what a company looks and acts like.

This strategy gets its name from its process and its ultimate goal: to systematically sort through volatility statistics of all of the stocks in a chosen category and select only the least volatile by a given yardstick. For example, a Fund that picks the lowest volatility stocks from the S & P 500 index using average daily rate of change in stock price might call itself a “Large Cap Minimum Volatility” Fund.

This results in a fund that typically is lower in volatility over long stretches of time. The goal, however, is not necessarily what you’d think it is. Low Volatility funds are not actually strategically picking stocks to minimize your downside in the short run simply for the sake of potentially losing less money- they’re actually seeking to make more than the average amount of money. They want long term outperformance.

Not to belabor the point too much, but this difference that may sound trivial is anything but. Investors who buy Low Volatility funds thinking they are buying something engineered to protect their principal are often shocked to learn that they’ve bought a quantitative strategy engineered for outperforming the market. This results in confusion.

“Beating the Market” is something investors often associate with high flying, high risk, deeply speculative gambles that somehow pan out at the end. While sometimes that’s the case, unstable, unproven, immature companies that attract the heaviest speculation are also frequently the biggest failures. As Andrew Ang of the Asset Management firm BlackRock said last summer, “more volatile stocks tend to have lower returns. In fact, we stated that stocks with the highest volatilities exhibited ‘abysmally low’ returns.” 1

The old saying “the higher the risk, the higher the reward” is not that true when it comes to stocks. There are plenty of newsletters, subscription services, and blogs that tout specific high risk stocks as the “next big thing,” but there isn’t much in the way of actual research to support the idea that buying them keeps pace with the broader market, let alone outperforms.

In reality, there is a well established “Low Volatility Anomaly” that demonstrates a paradoxical relationship between lagging the market in volatility and beating the market in returns. 2 Low Volatility portfolios are built to exploit this anomaly. Portfolio managers of funds using this strategy may occasionally market their funds as more conservative or built for the risk averse investor. At the end of the day, the point is always to achieve high returns over long time frames.

There are a few things that are simultaneously true about Low Volatility portfolios.

1. They really do pick the Lowest Volatility stocks.
2. Low Volatility funds are not generally trying to predict what investments will be most conservative.
3. Low Volatility portfolios heavily overweight certain sectors by nature, as some sectors are less volatile.
4. Sectors that are “defensive” during some market conditions can become less safe unexpectedly.
5. Low Volatility funds lost more during the depth of the Covid 19 crisis (3).
6. Investors often purchase these investments because they think they’ll be “safe.”
7. Portfolio Managers of Low Volatility portfolios are seeking to exploit the “Low Volatility Anomaly” (4).

This strange brew of facts should be pointing toward one conclusion: financial products have labels that can be accurate through one lens but also widely misunderstood. In my opinion, having had the chance to interact with some of the portfolio managers of large Low Volatility ETF’s, I don’t believe that Wall St. finds this misleading. They see themselves as technically correct. Frankly, they are. I think that investors need to become better educated on quantitative investing strategies if they are going to use them. Advisors, as well, need to actually read and/or understand the academic research behind quantitative strategies before selling them for separate purposes (i.e. heavily allocating to “Low Volatility” stock ETF’s as a risk management strategy in place of other, more suitable risk management solutions).

Below, you’ll find a chart showing underperformance this year of the Low Volatility Factor. Year over Year, Low Volatility has fallen 7.1% below the S & P 500 index.