Low-volatility stocks have outperformed the general market, and that trend is expected to continue, according to a white paper.
The BMO Global Asset Management U.S. paper, Low-volatility Equity Investing, notes that this anomaly has persisted over the past 90 years, and it’s one of the more surprising market anomalies uncovered to date.
“In theory, return is supposed to have a positive correlation to risk,” says Ernesto Ramos, the company’s head of equities. “Higher-risk stocks are supposed to deliver higher returns, and lower-risk stocks are supposed to deliver lower returns. If this 90-year-old pattern were to continue, as we expect, the low-volatility anomaly may provide a nice opportunity for prudent investors to make outsized returns.”
The white paper suggests a number of potential reasons behind the low-volatility anomaly and why it is likely to continue in the future.
- Money flowing into benchmark-driven strategies, such as index funds and exchange-traded funds, distorts the market and makes low-volatility stocks even more undervalued. This, in turn, increases their potential return.
- High-volatility stocks continue to be overbought, as investors continue to exhibit behavioural finance biases rooted in human psychology; these include the “lottery” effect and a preference for “glamour” stocks, among others.
- Structural conditions in the money management business, such as the option-like nature of compensation of equity managers, encourage them to avoid low-volatility stocks in favour of high-risk stocks. This may be enough of a bias to explain the low-volatility effect.
“Low-volatility investing represents a surprisingly significant potential opportunity for investors to earn excess returns over the benchmark,” Ramos notes. “With that in mind, investors would be wise to consider an allocation to low-volatility equity strategies in their portfolios.”