Low Risk Equities Outperform High Risk Ones

Includes: HVOL, LVOL, SPLV
by: ETF Prophet

By Engineering Returns

Traders seek to find the next big thing along the lines of Apple (NASDAQ:AAPL), Baidu.com (NASDAQ:BIDU), etc. Oftentimes this desire is founded by the underlying assumption that taking higher risk is rewarded with higher returns. Furthermore many traders believe in an efficient market whereas one can outperform the market only by taking above average risk. However this hasn’t been the case for the US stock market over the last couple of decades or so. A lot has been written about the low-volatility anomaly in financial markets. With this post I want to share some insight into how this works out on key index stocks over various time frames.

The Setup

For my research I define risk in terms of historical volatility. I looked into S&P 100 and S&P 500 stocks (survivorship bias free) from Jan. 1990 until Nov. 2011. Stocks are ranked by historical volatility of various time-frames (20, 50, 100, 252 and 500 days). I tested buying the top or bottom decile (long only). So for the S&P 500 index the strategy is always invested in the top/bottom 50 stocks whereas for the S&P 100 the strategy is always invested in the top/bottom 10 stocks. The test and all calculations are done using daily bars, re-ranking/rotation weekly. No trading costs were considered.

The Results

Thoughts & Observations

  • Low volatility (low risk) outperforms high volatility (high risk) on an absolute as well as risk adjusted basis
  • The anomaly is consistent among all volatility time-frames (20, 50, 100, 252 as well as 500 days)
  • Buying bottom decile (low volatility) outperforms index buy and hold (without considering trading costs)
  • The same test has been conducted for Nasdaq 100 stocks with confirming results (and conclusions).

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