It is relatively easy to demonstrate the low volatility anomaly – the phenomenon that first came to light half a century ago showing that investing in higher risk equities is not necessarily rewarded with higher returns. Raul Leote de Carvalho explains.
Here is a relatively simple example. Ranking stocks by their three-year historical volatility and then dividing this universe into quintiles from the least volatile to the most volatile every month, we can build five equally weighted equity portfolios.
While the volatility of the quintiles portfolios differs significantly (see Exhibit 1), the same cannot be said about their returns: Over this period, the returns of higher volatility stocks was practically the same as that of the least volatile stocks.
Higher risk-adjusted returns
In turn, Sharpe ratios, i.e., the average returns in excess of cash divided by volatility, are inversely proportional to volatility, with the higher Sharpe ratio for the least volatile stocks and the lowest Sharpe ratio for the most volatile stocks.
Basis: MSCI World index, Jan 2003 through May 2022; monthly returns in USD; rebalanced monthly. Source: BNP Paribas Asset Management, MSCI, FactSet, Bloomberg. For illustrative purposes only
We believe the results shown in Exhibit 1 are robust. Similar conclusions would be found by changing the period used in the simulations, for example, by extending it further into the past.
Such results can be found practically everywhere in developed and emerging stock markets, in different regions and even in different sectors of activity as we showed in our 2015 paper “Low risk anomaly everywhere: evidence from equity sectors” in the book “Risk Based and Factor Investing”.
Mitigating investment risks
BNP Paribas Asset Management has been among the leaders in factor-investing solutions — including low-volatility investing — since 2009, as we seek to serve investors keen to diversify their portfolios and target higher risk-adjusted returns.
Our low-volatility strategies aim to improve risk-adjusted returns compared to traditional market capitalisation indices. We do this by systematically exploiting low-volatility alpha and mitigating investment risks over the long term.
Integrating sustainability-related objectives has become crucial in meeting investor expectations and needs. That is why our quantitative investment team has these two objectives:
- Increase the portfolio’s score on environmental, social and governance (ESG) criteria relative to the ESG enhanced index (the benchmark minus 20% of stocks with the worst ESG scores)
- Reduce the carbon footprint of portfolios by 50% relative to the benchmark’s carbon footprint.
For our low-volatility strategies, sustainability-related investing acts as a third dimension. Investors can tailor their investments based on these objectives:
- The return they expect
- The risk they are willing to take
- The sustainability-related objectives they seek.
2 Five equal parts, each being 1/5th (20%) of the range
3 For more on factor investing, go to Factor investing – BNPP AM Luxembourg professional investor (bnpparibas-am.lu) or the relevant pages of your country website