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The stock market sell-off late last year was a reminder of how quickly a spell of bearish sentiment can start feeling like a full blown rout. Go-go growth stocks were pegged back, fast momentum plays were pummelled and even high quality firms saw their prices tumble.
Seasoned investors rightly say that short term pain is the price you pay for owning an asset class (equities) that outperforms over the long run. If you can live with periods of fear (of a permanent loss), then stocks offer the best long-term returns.
But not everything in the stock market is equal. Some shares are very sensitive to the daily ebbs and flows of sentiment, while others are unphased by what the market’s is doing (beta). Some swing wildly around their long term average prices, while others are much more settled (volatility). Understanding the difference can help to introduce some volatility diversification into a portfolio.
In unsettled conditions, shares that are less sensitive to the market mood have been shown to perform better. While these kinds of low volatility shares don’t tend to outperform in bull markets, they can hold up much better when there’s blood on the streets. In fact, over the long term, low volatility (or lower risk) stock strategies have been shown to be the more profitable approach.
This finding was originally made in research by the late Professor Robert Haugen, who claimed that the idea that “high risk equals high reward” was a misconception. He suggested that overconfident investors tend to bid-up the prices of riskier stocks - which then subsequently underperform.
Haugen’s conclusion has since been backed up by other studies. Betting Against Beta by Andrea Frazzini and Lasse Heje Pedersen (of the hedge fund AQR Capital), and The Value of Low Volatility by David Blitz (of Robeco) both find that low volatility is a powerful effect.
Frazzini and Pedersen found that “high beta is associated with low alpha” and that investors gravitate towards riskier stocks in the misplaced belief that they’ll produce superior returns over lower-beta stocks.
Calculating volatility in the stock market isn’t simple. In the case of beta, it’s is a direct measure - often taken over several years - of how sensitive a stock price is to the movement of the wider market. If a stock’s price tends to rise more than the market on up-days and fall more than the market on down days, it will have a beta greater than 1. But if it isn’t as sensitive to market movements, rising, or falling, less than the market, then it will have a beta of less than 1.
Another way is to look at a stock’s standard deviation. This is a mathematical way of seeing how much a company’s share price moves away from its average over a period of time. Three-year standard deviation is a core component of our Risk Ratings, which score stocks as either Highly Speculative (highest volatility), Speculative, Adventurous, Balanced or Conservative (lowest volatility).
To get an idea of the kinds of stocks passing some of the tests for low volatility, here’s a screen using some of these measures. The rules include:
FTSE 350 & SmallCap shares
Only Conservative and Balanced Risk Ratings
A beta of less than 0.8
In addition, the list is restricted to companies with a StockRank (our ranking of each share’s Quality, Value and Momentum) of more than 80. This is a nod to the fact that while risk and volatility are worth taking seriously, it’s also important to consider valuation and whether the stocks display good quality and strong momentum. (You can find the screen here)
Name | Mkt Cap £m | Beta | Risk Rating | StockRank Style | Price Chg 1y (pc) | Yield Rolling 1y (pc) |
29,252 | 0.78 | Conservative | Style Neutral | +13.2 | 5.67 | |
1,895 | 0.58 | Conservative | Style Neutral | +55.0 | 2.50 | |
72,509 | 0.77 | Conservative | High Flyer | +21.1 | 2.40 | |
8,229 | 0.77 | Conservative | High Flyer | +21.6 | 2.17 | |
12,612 | 0.53 | Conservative | High Flyer | +14.0 | 2.10 | |
5,736 | 0.71 | Conservative | High Flyer | +25.2 | 1.13 | |
4,884 | 0.58 | Balanced | Style Neutral | -4.16 | 7.98 | |
621.3 | 0.45 | Balanced | Super Stock | -7.28 | 7.74 | |
22,564 | 0.71 | Balanced | Super Stock | -6.82 | 6.66 | |
3,292 | 0.73 | Balanced | Style Neutral | +22.8 | 5.63 |
One of the interesting things about low volatility stocks is that they don’t change much. When you go looking for stocks that rate well for their exposure to factors like quality, value and momentum but also have low beta, low volatility traits, the names are often familiar.
I’ve been running this screen since we launched the Risk Ratings in mid-2017, and firms like Smith & Nephew, John Laing, Diageo and National Grid have often been present. Many of these firms have reputations for being solid and dependable - and that reflects some strong price gains over the past year.
So after a choppy few months in the market - especially for growth and momentums stocks - it’s worth considering how to diversify some of that volatility risk and opt for more predictable names. There are no certainties, and lower volatility stocks can become expensive in uncertain times. But low volatility stocks can be better placed to withstand market turmoil, which means they’re a useful way of spreading risk in a portfolio.
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Not sure if it will copy across, but I put together a basic screen based on van Vliet’s book (another Robeco quant) discussed in a similar article by Ed Croft a while ago. Throws up some interesting names, several of which I hold. For the “alpha” element I used an “RS6m >0” filter.
https://www.stockopedia.com/screens/high-returns-from-low-risk-van-vlieted-croft-june-231694/
Gus.
For the “alpha” element I used an “RS6m >0” filter.
You've also got "Price Chg 1y" > rank("Price Chg 1y",50) (i.e. price change greater than median) which is doing a similar job over the one-year period.
I notice your screen is not using 'beta' and I must admit I am not keen on using beta as a proxy for volatility. It tends to be a mess because low beta can either be because of low volatility of the stock, or because of low correlation with the market. And in turn, low correlation with the market is either good or bad depending on which way the market is going!
So at the risk of sounding like a broken record, I much prefer the Sharpe Ratio (price chg/volatility) as a way to use volatility. If the Sharpe Ratio of a stock is greater than the Sharpe Ratio of the market then in effect it has positive alpha: i.e. its returns are better than you would expect by simply using leverage on the market (beta).
A very easy way to invest in low volatility international stocks is to buy this Exchange Traded Fund:
https://www.stockopedia.com/etf-prices/ishrs-edge-msci-wrld-minvol-usd-etf-LON:MINV/
Sorry my link was to the US dollar version of that ETF. Here is a link to the GB pounds version:
https://www.hl.co.uk/shares/shares-search-results/i/ishares-vi-edge-msci-world-min-volatility
Yes lower vol stocks perform better in aggregate. But give me a volitile high div issue near it's 26 week lows any day. Volatility in toppy products is the killer.
*Past performance is no indicator of future performance. Performance returns are based on hypothetical scenarios and do not represent an actual investment.
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Slight problem with this screen. Direct Line Insurance (LON:DLG) and Marston's (LON:MARS) may have a low beta, but they also have a negative alpha - which is not very conducive to good performance!
You can't screen directly for alpha with Stocko, but a decent approximation would be to add a rule which tests for "RS 1y" > 0 . (This also takes out £BT-A which has an alpha very close to zero at the moment.)
(PS: where has the green "help" button on each page gone?)