The low volatility factor explained

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The low volatility factor provides a mechanism for investors to control risk while generating similar, if not superior, investment returns relative to the market over the long run.

Like quality, low volatility is a defensive factor that protects investors from heavy losses in bear markets while also capturing most of the gains to be had during market upturns.

The prices of stocks that fit the low volatility profile tend to fluctuate less than the market – in other words, such stocks have low beta exposure.

Quantilia’s data shows that in the US, low volatility stocks are less correlated to the market than other factors, including value, momentum, quality, size, and yield.

Over the past three years, this factor has also reflected the most muted drawdowns (peak-to-trough declines) and least volatility.

While traditional financial theory suggests that excess returns are a function of taking on extra risk, the low volatility factor contradicts this sentiment. Analysts usually cite behavioural biases to explain this anomaly.

Quantilia’s low volatility reference basket outperformed the US market by just over 1% between February 2013 and December 2016, with outperformance in 25 of the 45 months.

The low volatility factor can be captured through factor-based indices, such as smart beta and risk premia strategies.

A low volatility smart beta index would typically offer long-only exposure to a basket of low volatility stocks, while a risk premia strategy might go long the low volatility stocks within an index while short selling those stocks which display the highest levels of volatility.