Regardless of what's going on in the markets or the economy, financial advisers know that most clients like their portfolio volatility in small portions, if at all.
Even though the practical meaning of volatility includes both up and down moves, it's the down part that investors tend to associate with volatility, which helps explain the growing appeal of targeted low-volatility strategies like the SPDR SSGA US Large Cap Low Volatility ETF (LGLV) and the Invesco S&P Low Volatility ETF (SPLV).
These types of low-volatility strategies are often promoted for their downside protection, which typically equates to losing less on the way down in exchange for lagging on the way up.
What many investors and advisers might not fully appreciate is the longer-term benefits of low-volatility strategies, regardless of market conditions. Contrary to investing fundamentals that associate risk with reward, it turns out the smoother ride of lower-volatility strategies can also provide superior long-term performance.
The so-called low-vol anomaly has been studied and preached in the academic communities for decades, but the growing popularity of factor-based strategies is shining fresh light on the upside of lower-volatility investing,
"What the academics have found is that lower-risk stocks tend to outperform higher-risk stocks over longer periods of time, say five, 10 or 15 years out, and for many investors this would be a preferred way to get equity exposure," said Nick Kalivas, senior equity ETF strategist at Invesco.
According to a research paper by S&P Dow Jones Indices, over the 28-year period through December, the S&P 500 Low Volatility Index had a 10.7% average annualized return, while the broader S&P 500 Index averaged 9.8%.
While the S&P had periods of outperformance, including during the tech bubble of the late 1990s, it has lagged the more concentrated low-vol index since 2008. The most important detail in the performance comparison is that the low-vol index, which includes the 100 least-volatile stocks in the S&P 500, beat the broader index with a 23% lower standard deviation, meaning a lot less volatility.
The relative outperformance of low-volatility investing, which academics have long described as perhaps the greatest anomaly in finance, has a relatively simple explanation related to inertia and the gambling spirit.
As Mr. Kalivas explained, there are structural dynamics that keep investors — especially large institutional investors — from making the most of the low-vol advantage because they are mandated to focus on benchmark performance and low-vol strategies can swing wildly away from benchmark weights.
"If pensions veer away from the indexes, they find themselves having to explain why they did that," he said. "And if you look at most low-vol strategies, they tend to be concentrated in sectors, with a high level of tracking error relative to market-cap-weighted indexes."
The gambling aspect supporting the low-vol anomaly gets into behavioral finance and what economists describe as a preference for lotteries, according to the research report.
The behavioral argument that no rational person would buy a lottery ticket against such overwhelming odds, and yet millions of people do, is used to explain the association with risk and reward.
As the report explains, the tendency to buy "volatility for volatility's sake, drives the price of the lottery-like stocks above fair value. This means that a portfolio that systematically excludes the most-volatile stocks — exactly what rankings-based low volatility indices do — is more likely to outperform over time, globally."
Key to investing in low-vol strategies is to understand the underlying strategy, especially the benchmarks on which the strategies are based.
For example, while most low-volatility funds are made up of the least volatile stocks in an index over a set trailing period, funds labeled minimum-volatility or minimum variance typically just re-weight indexes without excluding any stocks.
The difference is significant, according to Mr. Kalivas, who said min-vol strategies have nowhere to hide in market pullbacks.
Leading up to the financial crisis in early 2007, for example, the low-vol S&P index had a 30% weighting in financial sector stocks. But by the end of the year, as the crisis took hold, the formula had trimmed the index's exposure to financials to just a few percentage points.
Min-vol strategies, by comparison, are tethered to the index and typically must stay within 5% of the index sector weights.
"The min-vol strategies can bounce back more quickly than low-vol during a rebound, but if you get into conditions like the tech bubble or the financial crisis, those strategies can't get out of the way," Mr. Kalivas said. "That's the power of the anomaly. When you buy low-vol, you get something that's very nimble."