A recent report1 by State Street Global Advisors examined this behavior, which refers to low-volatility stocks’ long-run outperformance even if they take on less risk — i.e. have lower beta — than the broader market. They conclude that this strategy has been a particularly strong performer in the Eurozone because of the region’s unstable macroeconomic background.
SSGA’s study found that for the past 15 years,2 the EURO STOXX® Low Risk Weighted 100 Index has had an annualized return of 9.5%, compared with 6.6% for its benchmark, the EURO STOXX® Index. The outperformance has come with a significantly lower risk profile, they add.
Interestingly, a similar advantage and relative risk patterns hold when shortening the comparative period to ten and five years, or even one year. The EURO STOXX Low Risk Weighted 100 Index gained 2.7% in the year to Apr. 18, compared with the EURO STOXX Index’s 1.5% advance.
“Europe has been lurching from crisis to crisis, and by taking less market beta, as well as lower idiosyncratic volatility, low-volatility strategies have managed to do well,” Daniel Ung, Senior Smart Beta ETF Strategist at SSGA, said in an interview.
“Meanwhile, the US has seen extraordinary growth for years and the economy is going into a late-cycle phase, something that often accompanies heightened levels of volatility,” Ung added.
Naturally more volatile
The EURO STOXX Low Risk Weighted 100 Index represents the 100 least volatile companies from the EURO STOXX Index. Constituents are selected on the basis of their twelve-month historical volatility and weighted by the inverse of that ratio.
A low-volatility strategy may be a more appropriate proposition for a region that is suffering high bouts of stress. According to SSGA, the median calendar-annualized volatility ratio for the EURO STOXX 50® Index since 1987 has been 17.4%. That compares with 15.2% for the Standard & Poor’s 500 Index.
Risk and returns
According to STOXX data, the annualized Sharpe ratio2 of the EURO STOXX Low Risk Weighted 100 Index is 0.7, compared with 0.3 for the EURO STOXX. The low-risk gauge’s annualized volatility in the past five years is 13.1%, lower than the 16.9% ratio for the benchmark. The volatility reading for the benchmark STOXX® USA 900 Index, for comparison purposes, is 13.4%.
“The positive alpha found in low-risk stocks explains why the Sharpe ratio of these strategies has been higher,” Ung said.
Yet, the strategist distinguishes between low volatility and low beta, or the systematic risk of a security relative to that of the market. That means that a low-volatility portfolio may not necessarily be made up mostly of industries that are less cyclical.
“Low-volatility stocks have low beta,” said Ung. “However, not all low-beta stocks have low volatility, and some higher-volatility stocks can be low beta.” Ung points to research showing that volatility and beta have a fundamental overlap of only about 55%3, meaning the two ratios are much more independent from each other than might seem the case.
This may be explained by the difference in which each factor ‘sticks’ on stocks through time. According to Ung, beta tends to change more than volatility over any given timeframe, making it less persistent. For example, the most and least volatile stocks tend to remain in those respective quartiles in the ensuing three, six and twelve months at a high proportion, SSGA says.
Volatility and seasonal patterns
The analysis could be of interest to investors since the most volatile seasons tend to overlap with the best-returns months, Ung said.
For example, October has shown the maximum and highest average volatility ratios for the EURO STOXX 50 Index in data from December 1991 through September 2018. October is, also, the third-best month for returns, yielding an average 2% during the period. Only April and December have provided better outcomes.
“In this context, low volatility could provide a way to gain equity market exposure with reduced levels of risk,” says Ung.
Different ways to target low risk
Beyond the Low Risk Weighted Indices, STOXX maintains a suite of minimum variance indices and indices tracking the low volatility premium and factor. It also manages the EURO STOXX® ESG-X & Ex Nuclear Power Minimum Variance Unconstrained Index, which employs a minimum-variance optimization approach with standard environmental, social and governance (ESG) exclusion screens.
Featured indices
- EURO STOXX® Low Risk Weighted 100 Index
- EURO STOXX® Index
- STOXX® USA 900 Index
- EURO STOXX® ESG-X & Ex Nuclear Power Minimum Variance Unconstrained Index
1 SSGA, “Is Low Volatility the ‘Right’ Investment Style for European Equities?” Ung, D., November 2018.
2 Net returns in euros as of September 2018.
3 Sharpe ratios based on one-month Euribor.
4 See Carvalho, et al., ‘Low-risk anomaly everywhere: Evidence from equity sectors,’ 2014.
