The low-volatility factor: Winning by losing less (until recently)

In the first instalment of this blog series we discussed the origins of the low-volatility ‘anomaly’, and in the second we explained why we believe downside volatility is a better measure of risk than standard deviation.

This time, we’ll examine the performance of low-downside volatility strategies.

The chart below shows the long-term performance of a model portfolio we’ve called the L&G Developed Markets Low Volatility strategy.[1] This strategy assesses the downside volatility of each stock in a representative market cap index. It uses historical weekly returns over the past three years, adjusting their weighting to favour those with higher scores, while reducing exposure to those with lower scores. The scores were generated using L&G’s proprietary Multi-Factor Scoring Framework.

Over the full period, the strategy has marginally outperformed the MSCI World, while exhibiting lower volatility. Over the past few years, the strategy has underperformed, although it still exhibits lower volatility than the MSCI World Index.

Mitigating drawdowns

The chart below shows the historical drawdowns of the model strategy against the MSCI World Index.

During stressed market conditions, the strategy has tended to either reduce the sharpness of drawdowns or recover faster when the drawdowns are very large – this is observed especially during the Global Financial Crisis and the euro debt crisis. Drawdown mitigation is more muted during the downturns in 2020 and 2022.

The below chart shows the asymmetry of returns of the model strategy. Even though the strategy underperformed the MSCI World Index during bull markets, it marginally outperformed over the full period because it outperformed during bear markets – winning by losing less.

Even over the shorter period (March 2020 to January 2024), the strategy has outperformed the MSCI World Index during months where the MSCI World Index returns are negative, showing that the strategy still provides some downside protection.

The rise of the Magnificent 7

The underperformance of the L&G Developed Markets Low Volatility strategy against the MSCI World since March 2020 can be partly explained by the increase in concentration of US tech giants, in particular the Magnificent 7.[2]

It has been widely observed that the fraction of US cap-weighted performance attributable to the Magnificent 7 has become unusually high since 2020.We illustrate this below, where we show the weights of the Magnificent 7 in the L&G North America Low Volatility strategy[3][4] versus a representative market cap index.

The Magnificent 7 performed well in 2020 and 2021, reducing these stocks’ relative downside volatility and leading to an overweight position in the L&G North America Low Volatility strategy. However, in 2022 they significantly underperformed the market-cap weighted index, causing the overweight position to contribute to overall underperformance.

Negative returns posted by the Magnificent 7 in 2022 caused an uptick in downside volatility, in turn leading to an underweight position in the L&G North America Low Volatility strategy. The Magnificent 7 significantly outperformed the index in 2023, meaning this underweight contributed to underperformance.

What next for low-downside volatility?

The underperformance of low-risk strategies over the recent past has led some investors to question the premise of low-risk investing. However, we do not believe that the underlying behavioural drivers of low risk have suddenly disappeared.

In our view, the data presented above shows that, over a long period, a strategy constructed using low downside volatility can exhibit higher risk-adjusted returns versus an equivalent market cap index.

The recent underperformance of a low downside volatility strategy can be attributed, as we’ve shown here, to index concentration, especially the Magnificent 7. It may be prudent to maintain low-volatility equity allocations, especially during a risk-off environment.

Key risks:

*For illustrative purposes only. Reference to a particular security is on a historic basis and does not mean that the security is currently held or will be held within an LGIM portfolio. The above information does not constitute a recommendation to buy or sell any security.

[1] Note the L&G Developed Markets Low Volatility strategy was constructed by applying the L&G factor methodology and is for illustrative purposes only.

[2] The Magnificent 7 refers to Alphabet*, Amazon*, Apple*, Meta*, Microsoft*, NVIDIA* and Tesla*.

[3] Note the L&G North America Low Volatility strategy was constructed by applying the L&G factor methodology and is for illustrative purposes only.

[4] Although we have switched to North America, the effect would be largely similar in developed markets as North America makes up the majority of the market capitalisation of developed markets.