In this article we will discuss our approach to volatility and how we want to mitigate portfolio volatility disregarding low volatility as a factor but treating it as a predictive number on a stock by stock basis, subsequently being conducive to a robust equity portfolio.
Conventional portfolio theory suggests reducing portfolio volatility will also reduce its expected return. This hypothesis is justified by the assumption that returns on equity are derived from risk premia. However, this hypothesis has in large part been at odds with empirical results, as low volatility stocks have historically outperformed high-volatility stocks. This phenomenon is commonly referred to as the Low-Volatility Anomaly. To illustrate this phenomenon, consider a simple test: assume that at January 1st 2004, we select a universe of the 50 largest companies in the world. Using this, we create two distinct portfolios, comprised of the 5 least- and most volatile stocks in that universe respectively. The low-volatility portfolio contains The Coca-Cola Co, Novartis AG, Chevron Corp, Exxon Mobil Corp, Johnson & Johnson. The high-volatillity contains HP, Intel, Time Warner, Orange, Oracle Corp. Holding each portfolio until 2018 results in the following performance.
Not only does the low-volatility portfolio achieve lower risk and higher Sharpe ratio, it also has a higher annualized return. This phenomenon is based on empirical evidence, as can be seen in figure 1.
Many market participants and observers have attempted to explain this phenomenon by various theories, like market inefficiencies derived from psychological aspects of traders and investors, or treating low-volatility as a ”factor” supposed to account for non-apparent risk exposures.
However, regardless of how one tries to explain the low-volatility anomaly, it remains in significant contrast to conventional portfolio theory and remains one of the best tools for generating superior long-term returns.
In the next article we will discuss various methods of risk reduction which is also an integral part of CIMalgo’s investment process.