Ways to Exploit the Low-volatility Effect

How can the low-volatility effect, whereby stocks with low past volatility tend to outperform the market on a risk-adjusted basis (but lag during long bull markets), help achieve common investment goals? In their October 2024 paper entitled “Leveraging the Low-Volatility Effect”, Lodewijk van der Linden, Amar Soebhag and Pim van Vliet test ways to use the low-volatility effect to support five distinct investment goals. Their low-volatility benchmark strategy each month holds the 100 of the 1,000 largest U.S. stocks with the lowest 36-month volatilities. They consider ways to exploit the effect in five ways:

1. To safely boost return, they integrate value (net payout yield) and momentum (return from 12 months ago to one month ago) with low-volatility by each month: (1) selecting the 500 of the 1,000 largest U.S. stocks with the lowest 36-month volatilities; and, (2) picking the 100 of these stocks with the highest combined net payout yield and momentum. 
2. To beat a conventional 60-40 stocks-bonds portfolio, they consider: (1) replacing 10% of stocks and 5% of bonds with a 15% allocation to Strategy 1; (2) assigning equal weights to stocks, bonds and Strategy 1; or, (3) allocating 70% to Strategy 1 and 30% to bonds.
3. To beat the stock market, they target a market beta of 1.00 via a 140% long position in Strategy 1, financed either by: (1) borrowing 40%, with credit spread plus the T-bill rate as the borrowing cost; or, (2) using equity market index futures, with annual return slippage and implicit costs 0.2%.
4. For absolute returns, they consider a 100% position in Strategy 1, offset by: (1) 48% short positions in speculative stocks (high volatility, low net payout yield and low momentum), assuming 2% annual shorting costs; or, (2) a 72% position in short equity market index futures, with 0.2% annual costs.
5. For crash protection compared to 5% out-of-the-money 1-month put options, they target a market beta of -0.50 by combining: (1) a 30% long position in the low-volatility benchmark with a 50% short position in speculative stocks, with credit spread over the T-bill rate as the borrowing cost; or, (2) a 70% long position in the low-volatility benchmark with a 100% short position in equity market index futures, with 0.2% annual costs.

In general, portfolio rebalancing is monthly. Using monthly data for the largest 1,000 U.S. stocks and for the other asset types specified above during 1990 through 2023, they find that: (more…)