How to protect your portfolio with Low Volatility stocks

Stock market investors have been dealt some heavy blows over the past three months. Even the FTSE 350 index of large and mid-cap shares fell by 10% during four stomach-churning weeks in September and October. But while there were certainly some hefty individual price corrections, a number of shares in the index were hardly affected at all.

Part of the reason why some shares are able to cope with volatile conditions is actually well known. Not only that, but it has been shown that so-called ‘low volatility’ stocks tend to outperform riskier stocks over the long term. They rise slower in bull markets but don’t fall as far in bear markets. In fact, decades of research suggests that the old stock market adage that high risk equals high reward is complete bunkum.

Meet the Low Volatility Anomaly

Academics and market professionals like Robert Haugen have been writing about the existence of the Low Volatility Anomaly since the 1970s. What they’ve found is that low risk stocks have higher expected returns. There is some debate about precisely why that is. But like many market anomalies, it seems that behavioural factors could be at play. In particular, investors gravitate towards riskier shares and are overconfident about picking winners. As a result, riskier stocks become overpriced and underperform, and that creates a value premium at the lower risk end of the market.

According to investment management advisors MFS, the Low Volatility Anomaly suggests that investors can achieve up to a third less volatility in their equity portfolios without sacrificing benchmark-like returns.

What is a low risk stock?

Researchers use numerous factors when it comes to measuring how risky a stock is. But in the study of low volatility, one measure that is often used is something called Beta. It’s a term that sounds insanely complex but Beta is just a way of measuring how sensitive a company’s share price is in relation to the 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 less and falling less than the market, then it will have a Beta of less than 1. On its own Beta isn’t a measure of volatility. But it can be used as a risk indicator to manage the exposure of a portfolio to market volatility. It can do that by helping to find the ‘defenders’ that Ed wrote about here.

Just take a look how the lowest Beta stocks in the FTSE 350 were fairing shortly after the market nadir in mid October. Apart from looking at just the Beta, we sorted the list for companies with a StockRank of more than 80 (you can read about StockRanks here). And we also added a red flag indicator in the form of the Altman Z-Score, which weeds out stocks with any hint of bankruptcy risk.

Over the previous three months the index had fallen by 6.6%. But the median average fall among the low Beta stocks was just -0.25%. In other words, as a group, they held up well during the market decline (the table shows the top 10 sorted by market cap). As you can see, the list is reasonably diversified, ranging from blue chip stalwarts like AstraZeneca and Reckitt Benckiser to mid-caps like housebuilder Berkeley Group and financial trading company IG Group. By contrast, the highest Beta stocks fell by an average 5.8%. Subscribers can click to see the current Low Volatility and High Volatility screens.

Name	Mkt Cap £m	Stock Rank™	Beta	Altman Z Score (1)	% Price Chg 3m
AstraZeneca	52,865	91	0.39	2.38	-3.76
Reckitt Benckiser	37,031	91	0.59	4.05	+0.40
Associated British Foods	20,338	81	0.65	5.61	-11.8
Compass	16,015	89	0.71	3.45	-5.85
Next	10,029	87	0.69	7.53	+1.63
Pearson	9,272	85	0.76	2.10	+2.35
Bunzl	5,497	83	0.74	4.09	+2.24
Berkeley	2,955	84	0.77	3.85	-10.1
DCC	2,741	95	0.70	4.25	-5.37
IG	2,230	80	0.42	16.9	+6.17

Based on data at 20 October, shortly after the market bottomed out

The recent market decline has invigorated the discussion about using low volatility to trim risk from a stock portfolio. More recently, the debate has focused on whether the Low Volatility Anomaly can be (or is being) arbitraged away. If that were the case, these apparently lower risk shares would attract more interest from investors and become more expensive as a result. But others argue that the emotional drivers that lead many investors to chase ‘lottery ticket’ stocks mean that this anomaly won’t disappear anytime soon.

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