Small Caps And Low Volatility: A Long-Run Study

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Includes: IJR, SPY, XSLV
by: Ploutos

Summary

As a follow-up to my demonstration of the structural outperformance of small-cap value stocks, I illustrate the outperformance in low volatility small-cap stocks.

Using a fifty-plus year dataset, I detail the annualized returns of portfolios formed based on size and low volatility.

Low volatility dominates high volatility and small-cap stocks dominate large-cap stocks; however, the size premium is negative in the highest risk cohorts indicating the need for a quality tilt.

In my recent articles on Small Cap Value, I illustrated the long-run outperformance of small capitalization stocks with low market-to-book ratios. In illustrating this outperformance, I noted that small-cap growth had lagged the returns of the market over time. In a cheekily entitled piece, "Size Matters, If You Control Your Junk," billionaire investor Cliff Asness of AQR Capital illustrated that by removing low quality, riskier, small-cap stocks the size premia is robust.

Similar to the long-run examination of the size and value factors, this article looks at a long-run study of size and volatility. Returning to the Kenneth French dataset, I examined the historical returns of 25 portfolios formed on size and volatility. The table below shows the annualized returns across these two factors dating back to 1963.

Click to enlarge

I believe that this is a very powerful table for investors. Here are a few of my takeaways:

  • The highest volatility portfolios (far right) underperform each of the other volatility buckets across each of the capitalization sizes. This is a topic that I covered previously in "The Losing Trade in the Stock Market is High Risk."
  • The second-lowest volatility portfolio and the lowest volatility portfolio typically generate the highest annualized returns.
  • In the lowest volatility and second-lowest volatility portfolios, annualized returns fall as the average size of the underlying companies increases. Said differently, low volatility is less powerful in large-cap stocks than small and mid-cap stocks.
  • This is completely reversed in the highest volatility bucket where the smallest stocks produce the worst returns and the returns rise as size increases.
  • The best returns (smallest capitalization/low volatility) and worst returns (smallest capitalization/highest volatility) both occur in the smallest capitalization cohort.

In my "5 Ways to Beat the Market," I have illustrated that small-cap stocks as proxied by the S&P 600 (NYSEARCA:IJR) have outperformed the S&P 500 (NYSEARCA:SPY) over long-time periods as compensation for the size premia. This article, and my recent articles on small-cap value, illustrate that marrying the size factor with value or low volatility has produced market-beating returns over long-time intervals. To enhance the returns from the size factor, investors should mind the quality of the underlying constituents and favor small-cap stocks that have generated lower volatility. Investors should also be mindful of the price that they pay for small cap stocks, and target stocks with relatively lower market-to-book ratios (i.e. value).

How do I capture the outperformance of low volatility small-cap stocks? I own the PowerShares S&P SmallCap Low Volatility Portfolio ETF (NYSEARCA:XSLV), which owns the 120 stocks with the lowest trailing one-year volatility in the S&P 600 SmallCap Index. As I illustrated in Small Cap + Low Volatility = Great Long-Run Returns, the underlying index for this exchange-traded fund has generated nearly 14% annual returns since mid-1995, besting the S&P 500 by 4.7% per year.

I hope this article highlights the long-run outperformance of a low volatility tilt within small-capitalization stocks. Please share how you capture the higher expected returns in small-cap, low volatility stocks in the comments section.

Disclaimer: My articles may contain statements and projections that are forward-looking in nature, and therefore inherently subject to numerous risks, uncertainties and assumptions. While my articles focus on generating long-term risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance and investment horizon.

Disclosure: I am/we are long XSLV, IJR, SPY.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.