MFS Capability

White Paper
Focus
Series
June
Month2014
2012

Authors

LOW-VOLATILITY INVESTING
REVISITED
James C. Fallon
Portfolio Manager

IN BRIEF

R. Dino Davis, CFA

Institutional Portfolio Manager

Investors are very interested in reducing the volatility of their portfolios

in the wake of the 2008 global financial crisis, while also being mindful
of returns.
The low-volatility anomaly suggests that investors can achieve up
to a third less volatility in their equity portfolios without sacrificing
benchmark-like returns.
The construction of a nave low-volatility portfolio can suffer from
many biases.
We believe an approach that incorporates fundamental research,
risk guidelines and optimization should result in better risk-adjusted
performance.
Investing in low-volatility strategies requires a long-term perspective
that will allow one to weather the underperformance in bull markets
balanced by the outperformance in bear markets.

Expect volatility and profit from it.

Ben Graham

BUILDING
BETTER
INSIGHTS

SM

Interest in reducing volatility and de-risking investment portfolios has

grown for both individuals and institutional investors caught in the
maelstrom of the 2008 financial crisis and the ensuing investment losses
and deep recession. No less pressing, though, is the imperative to maximize
portfolio returns given the low-return environment that has followed from
the expansionary monetary policies pursued by central bankers to combat
the recession. The income demands of an aging population in the
developing world further underlines the return imperative.

FOR INSTITUTIONAL AND INVESTMENT PROFESSIONAL USE ONLY.

JUNE 2014

/ LOW-VOLATILITY INVESTING REVISITED

The tension between the desire to de-risk and the need to

bolster returns is undoubtedly one of the most significant
investment themes of our time.

Exhibit 1: Annualized relative return by volatility decile

4%
Highest volatility

Alongside a variety of other investment products, lowvolatility investing has emerged in the wake of the demand
for equity-like returns without the tail risk of traditional
equity. Low-volatility investing was first identified in the early
1970s by the legendary Fischer Black and Myron Scholes,
and reaffirmed by Eugene Fama and Kenneth French in
1993. The empirical academic research has shown that over
the long run one can achieve benchmark-like returns with
significantly lower volatility (about two-thirds to a quarter of
the volatility).1,2 This finding appears to fly in the face of
modern portfolio theory, which holds that risk and return are
positively correlated. This investment anomaly also holds true
across asset classes and spans almost every major market,
including the United States, the United Kingdom, Japan,
Australia, Germany and Canada.
The following graph shows the annualized return of the
1,000 largest US stocks from December 1979 to December
2013 based on their volatility decile. It clearly shows the lowvolatility anomaly, i.e., that low-volatility stocks outperformed
their more volatile counterparts (see Exhibit 1).

Relative return

Portfolios can reduce risk in a number of ways, ranging from

diversifying asset classes and strategies to adding more
managers and liability-driven investing (LDI), along with
absolute return and hedging strategies. Interest in LDI, in the
form of dynamic de-risking, enterprise beta-matching,
completion portfolios and duration-matching portfolios,
predated the financial crisis. Other ways of reducing volatility
include managing tracking error with enhanced index
strategies, investing in asset allocation portfolios that manage
investments in various asset classes and investing in lowvolatility equity portfolios, which can also adopt a blended
approach that includes the addition of fundamental alphagenerating capacity, as we will discuss in this paper.

0%
Lowest volatility
-4%

-8%

-12%

D1

D2

D3

D4

D5

D6

D7

D8

D9

D10

Sources: Factset. MFS research methodology: Stocks were placed into deciles
monthly, with volatility calculated over 24 months. Data from December 1979
December 2013. Universe defined as the 1,000 largest US stocks by market
capitalization. Returns are relative to that universe. Based on returns linked
monthly.

This anomaly is largely attributed to the structure of the

investment industry, in particular the widespread adoption of
relative benchmarks, as well as behavioral investing factors
that lead investors to make seemingly irrational decisions.
(For further details on the anomaly see the sidebar: Will the
low-volatility anomaly persist?).

Low-volatility investing in practice

Various strategies have been specifically designed to produce
a portfolio that delivers less volatility than the broad equity
market. The most common include those that are limited to
a low-volatility universe, those that are focused on minimal
variance using a predicted risk model and those positioned
to meet a beta or other volatility target. These strategies
produce portfolios that are heavily weighted toward the
least volatile 20% of stocks, a bias closely aligned with
interpretations of the low-volatility anomaly.
In our view, these are based on a narrow interpretation of
the low-volatility anomaly, which asserts that the lowestquintile stocks based on volatility outperform the market
over the long run. These least volatile stocks might be
equal-weighted or weighted based on each names level
of volatility. The S&P 500 Low Volatility Index is an example
of such a low-volatility investment strategy.

JUNE 2014

/ LOW-VOLATILITY INVESTING REVISITED

Minimum variance strategies typically include a broader

universe of stocks than the least volatile 20%, employ a risk
optimizer and incorporate basic constraints regarding
industry, sector and country weights to produce a portfolio
with a predicted minimum possible volatility. MSCI offers
several minimum variance indices that use this method.
Simply put, a true minimum variance portfolio would
concentrate the vast majority of the portfolio in just a
few stocks. As constraints are added (e.g., a maximum
individual weight of five percent), the optimizer adds more
positions to the portfolio with a goal of minimizing the
portfolios volatility.

low-volatility universe, these portfolios typically share a

dividend yield that is higher than the respective indices.
Simulated and real-world examples show that these features
can be maintained over the long run while achieving a return
similar to that of the major indices.

Beta target portfolios are not limited to the least volatile

20% of stocks, nor are they necessarily driven by a risk
optimization engine, but rather are designed to produce a
beta that is much lower than a corresponding index. These
portfolios can have some high-volatility stocks but are
weighted toward lower beta names to achieve the targeted
portfolio-level beta. Although there is clearly some correlation
between beta and volatility, the idea behind beta target
portfolios is that they will follow the direction of an index
more closely than a targeted volatility approach since beta is
a benchmark-relative measure and volatility is not.
Targeted volatility strategies use a predictive risk model to
construct a portfolio that has an acceptable level of risk. This
can be an absolute or a relative level of volatility. These
strategies can use a broad set of stocks, incorporate
constraints for industries, countries and regions and
depending on the risk optimizers capabilities constrain
other biases such as size and style.

Portfolio characteristics
Regardless of whether a low-volatility method is based on a
strict interpretation of the low-volatility anomaly, a minimum
variance approach, a beta target or a volatility target, these
strategies tend to produce portfolios that share similar
characteristics.
First, since they are all volatility-driven approaches, they share
overweight positions in many of the same low-volatility
names, as well as underweight positions in the same highvolatility names. Second, even if the method is not explicitly
beta targeted, these portfolios tend to arrive at the same
beta of around 0.60. Third, whether or not the method is
explicitly volatility targeted, these portfolios tend to reduce
volatility over the long run by about 25% to 35%.1 Fourth,
because certain industries tend to consistently fall within the

Along with the favorable characteristics described above,

these strategies also often share some less desirable features,
including concentrated sector weights, concentrated
positions, extreme biases in small capitalization stocks and
large weights in stocks that have low liquidity, as well as
weak analyst coverage. Exhibit 2 below illustrates a typical
sector bias associated with low-volatility strategies. It shows
that 41.6% of the weight in this portfolio was concentrated
in utilities and financials.
Exhibit 2: Low-volatility strategies can exhibit high
concentration
Utilities 23.5%
Financials 18.1%
Industrials 16.5%
Consumer staples 16.4%
Materials 8.1%
Health care 8.1%
Energy 3.2%
Information technology 3%
Consumer discretionary 2.2%
Telecommunication services 0.9%
Source: S&P 500 Low Volatility Index 21 May 2014.

The lack of diversification inherent in the concentrations

described above exposes the portfolio to unpredictable risk.
We have seen, for instance, that industries and countries
rotate from high volatility to low volatility, and vice versa. For
example, technology in the US has rotated from being one
of the highest-volatility sectors to one of the lowest, and
now ranks among the highest again. Banks, which prior to
2007 were regarded as low volatility, are another example.
An unconstrained low-volatility portfolio would have been
dangerously exposed to the financial sector during the global
financial crisis since this sector had been the least volatile and
rapidly became the most volatile. The Japanese tsunami
example is illustrative. Prior to this natural disaster in March
2011, Japan and its utilities sector appeared attractive based
on volatility, and a global low-volatility strategy would likely
have been overweight Japan and the utilities sector.

JUNE 2014

/ LOW-VOLATILITY INVESTING REVISITED

Low-volatility investing 2.0

Exhibit 3: Long-term change in volatility: Comparing

the two most recent 15-year periods for the largest
1,000 US stocks

Given the concentration tendencies described above, we

believe that a low-volatility portfolio is likely to perform
better over a longer time horizon if it is broadly diversified,
includes liquid stocks that are well known by analysts and
also incorporates stock-level research rather than being
exclusively driven by a desire to invest in the least volatile
stocks. To achieve this, we recommend avoiding historically
high-volatility stocks, employing traditional rules of portfolio
diversification, incorporating fundamental input and
optimizing as with a minimum variance framework.

40%
35%
30%
25%
20%

35%

15%
10%

15%

5%

Avoiding high-volatility stocks

0%

Our research has shown that high volatility tends to be

concentrated in about 40% of stocks within a universe, a
phenomenon that occurs fairly consistently within global
regions. This same group of stocks tends to underperform
over the long run. For the remaining less volatile 60% of
stocks, volatility is distributed more evenly over the long run.
During market declines, however, the least volatile 20% have
outperformed more dramatically and with significantly less
volatility. Rather than using an approach driven by a small
number of stocks focused toward the lower volatility quintile
based on their strong down-market performance, we believe
that eliminating the most volatile 40% of stocks allows an
investor to benefit from a better risk-adjusted return over full
market cycles. By eliminating the high-volatility stocks, we
can design a portfolio that takes full advantage of the
remaining 60% of the investment universe to construct a
more robust low-volatility portfolio.
Exhibit 3 shows the change in market volatility driven by the
most volatile 40% of stocks in a universe of 1,000 of the
largest US stocks over two 15-year periods.

6%
Largest 1,000
US stocks

Least volatile 600

Most volatile 400

Sources: Factset. MFS research methodology: Stocks were placed into deciles
monthly, with volatility calculated over 24 months. Data as of 31 December
2013. Largest 1,000 U.S. stocks. Graph compares two windows: Volatility from
January 1984 December 1998 with January 1999 December 2013.

Enforcing the rules of diversification

The benefits of diversification have been widely documented:
Greater diversification lowers overall investment risk. Sectors
can unpredictably rotate from low to high volatility, and
indices can reflect inflated weights in market leaders and
in-vogue sectors. The shifts can often be short term and
dramatic, as we have seen most recently in the banking
sector. Even in a low-volatility framework, diversification
is critical.
To ensure that certain industries, sectors or regions do not
dominate a portfolio, we recommend constraining portfolio
exposures to long-term market averages rather than the
most recent market capitalization. The result is a portfolio
that maintains some exposure to all investable areas of the
stock market while minimizing exposure to potential nearterm market bubbles. Risk optimizers also provide the ability
to control other biases such as size, liquidity and style
that might otherwise produce a portfolio that no longer
matches the universe it represents. We recommend including
some rules that ensure that the portfolio is consistent with
the index it is measured against. For example, a low-volatility
portfolio of US stocks compared to the S&P 500 Index might
look more like the Russell 2000 Value Index because of the
biases in the low-volatility universe.

JUNE 2014

/ LOW-VOLATILITY INVESTING REVISITED

Applying fundamental research

A typical low-volatility strategy makes no assumptions
about the relative attractiveness of each company. Nor
does it necessarily distinguish between the liquidity of
stocks and how well they are covered by analysts. Instead,
the focus is solely on a stocks volatility, without regard to an
expected return forecast. We believe this is a shortcoming of
these strategies.
Adding fundamental analysis to a low-volatility universe
offers the opportunity to generate additional return for an
investor. Not all low-volatility stocks will have the same
prospects, risks, balance sheets or liquidity. Given that smallcap, less-liquid and weakly covered stocks can represent a
large portion of a typical low-volatility portfolio, we believe
that incorporating fundamental research is not only
advantageous, but critical. Additionally, focusing on the 60%
least volatile stocks rather than the 20% least volatile stocks
provides a broader opportunity set for fundamental research.
Analyzing fundamentals is particularly important when
valuations are high at certain points in the market cycle and
when volatility tends to be marked, as in the case, for
instance, of global strategies that may invest in cyclically
volatile regional markets.

Optimizing in a minimum-variance framework

Once the universe has been established, diversification
constraints have been determined and information from
fundamental research has been applied, one has the
framework required to optimize a portfolio to a desired level
of risk. Risk optimizers typically employ a multifactor risk
model that considers sources of systematic risks such as
industry, capitalization, valuation and financial leverage as
well as a companys unique, or idiosyncratic, risk.

level of volatility for US stocks that are about 25% to 30%

lower than the S&P 500.1 In a global portfolio, volatility can
be reduced even more because of the larger universe of
stocks that are available for optimization. For minimum or
targeted variance optimizations, we recommend that
portfolios be modeled to a risk-free asset such as cash; the
low-volatility objective should not be aligned with capturing
the beta of an index. By optimizing to an index, the tool will
seek to match the risks of that index. By optimizing to a risk
level compared to cash, the optimizer avoids much of the
risk characteristics of the index. The result is a portfolio
expected to produce a positive return at a level of risk that is
20% to 35% less than that of the corresponding market.

Low-volatility portfolio construction models

To illustrate these points we created four model portfolios:
a market portfolio and three low-volatility equity portfolios
(see Exhibit 4 on the next page). The market portfolio
consists of the largest 1,000 stocks in the United States;
Portfolio A comprises the 200 least volatile stocks; Portfolio
B the 600 least volatile stocks; and Portfolio C the 600 least
volatile stocks combined with certain risk guidelines and
optimization. These risk guidelines include sectors and
industries set to +/-5% compared with the S&P 500 monthly
weights; a soft turnover constraint limited to 8% monthly;
and a size constraint that controls to avoid a small cap bias
compared to the Barra estimation universe. Portfolio C is
optimized against cash to produce a minimum variance
portfolio. The portfolio results are shown for two time
periods, a 23-year period from December 1989 to December
2012 and a 15-year period from January 1999 to December
2013. The latter time period is included to reflect the
significant recent volatility.

These optimizers can be effective in helping to find an

appropriate balance of expected risk and return. Depending
on the investment universe and investment constraints used
in an optimization, minimum variance strategies achieve a

JUNE 2014

/ LOW-VOLATILITY INVESTING REVISITED

process applied to Portfolio C avoids the selection of an

illiquid portfolio (the average daily trading volume actually
rises in Portfolio C compared with the market portfolio). Of
the three low-volatility portfolios, only Portfolio B displays
less liquidity than the market portfolio, measured in terms
of average daily trading volume, and introduces another level
of risk into the portfolio.

Exhibit 4: Model portfolio risk and returns:

December 1989 December 2013
Market*

Portfolio A

Portfolio B

Portfolio C

Risk and return

Entire period: December 1989 December 2013
Annualized
return

11.4%

11.6%

12.2%

11.4%

Annualized
std dev

17.5

11.0

13.7

11.9

Risk
reduction %

N/A

37%

22%

32%

While savvy investors will rightfully point to certain

difficulties associated with comparing equally weighted
portfolios of different sizes, we include these model
portfolios here to illustrate how the low-volatility anomaly
can be observed and also to show how some of the biases
of low-volatility portfolios can be addressed with risk
guidelines and optimization, in addition to fundamental
analysis, as discussed above.

Risk and return

Past 15 years: January 1999 December 2013
Annualized
return

8.9%

9.1%

9.5%

13.0%

Annualized
std dev

19.3

11.7

15.0

11.1

Risk
reduction %

N/A

39%

22%

42%

Implications for investors

US plan sponsors ranked de-risking and managing volatility
as top concerns, second only to asset allocation decisions, in
Greenwich Associates 2012 research among institutional
investors. If one believes investors should continue to
minimize volatility in their equity portfolios, as many
institutional investors do, avoiding high-volatility stocks is a
good first step, but a relatively naive construction of a lowvolatility portfolio can suffer from many biases, rendering the
portfolio effectively un-investable, or at least undesirable.

Risk management review

As of December 2013
3 largest
sectors

38%

52%

43%

43%

Avg Fwd P/E

17.8x

17.2x

17.9x

18.2x

Avg daily
trading vol
(mil)

$139

$143

$126

$1,802

17

17

17

19

Avg number of
IBES estimates

Sources: Factset, MSCI Barra, MFS research.

*Market: 1,000 largest US stocks; Portfolio A (20%): 200 least volatile
stocks; Portfolio B (60%): 600 least volatile stocks; Portfolio C (60% +
risk): 600 least volatile stocks with risk guidelines.

The risk-return profile of these portfolios validates the

low-volatility anomaly, i.e., these portfolios provide
benchmark-like returns with up to a third less volatility.
Portfolio C shows a 42% reduction in risk measured in
standard deviation in the 15-year time period. The
concentration risk, which tends to result from a narrow focus
on lower-volatility stocks, is evident; however, this is
mitigated in Portfolio C with the risk guidelines and
optimization process applied. Similarly, the risk management

The strategies discussed in this white paper offer ample

opportunity for improved risk-adjusted performance through
stock selection, risk management and portfolio construction
with a broader universe of less volatile securities. Because of
higher tracking error (but lower absolute risk) and the
episodic investment performance of low-volatility portfolios,
investing in such strategies requires a long-term perspective
that will allow one to weather the underperformance in bull
markets balanced by the outperformance in bear markets.
1

Baker, Bradley and Wurgler (2011) Financial Analysts Journal,

vol. 67, no. 1 (January/February): 1 15.
Fama, Eugene F. and Kenneth R. French (1993) Common Risk Factors
in the Returns on Stocks and Bonds, Journal of Financial Economics,
33:1, pp. 3 56.

JUNE 2014

/ LOW-VOLATILITY INVESTING REVISITED

Q: In addition to the point you make about the importance

of benchmarks, behavioral explanations of the low-volatility
anomaly have been cited. This is the work of Daniel
Kahneman, who received a Nobel Prize for his research
on cognitive biases. Essentially, this research shows that
people have an irrational preference for high-volatility
investing, as evidenced by the lottery effect, among others.
Do you think this is also a factor?

Will the low-volatility anomaly persist?

The low-volatility anomaly has been ascribed to numerous
factors, among them the entrenched role of relative
benchmarks along with cognitive biases and other behavioral
distortions, as well as the role of compounding. Portfolio
Manager Dino Davis comments below on the
low-volatility anomaly.

Dino Davis: The most important reason for this investment

anomaly is the entrenched use of relative benchmarks. As
long as people think of volatility relative to a benchmark, this
anomaly will continue to exist. The concern with keeping up
with a benchmark is felt particularly by institutions that hire
plan managers on this basis and assess tracking error relative
to a benchmark. Low-volatility strategies can be unattractive
because they have high tracking error. For this to change,
investors need to be encouraged to no longer focus on
relative benchmarks, but rather concentrate on accumulating
wealth at a reasonable rate over a long time horizon.

Dino Davis: I agree that this is also a reason, but its not
the main driver. The dominance of institutional investors in
the market significantly dampens this effect since it is much
less pronounced in the context of group decision-making.
Behavioral factors are less important when, for instance, you
have consultants advising funds and investment committees
overseeing the investment strategy.
The power of compounding is an additional factor to
consider in this context. Lower-volatility stocks benefit
from lower risk drag or from volatility drag, which
depresses the long-term performance of the higher-volatility
stocks because of the compounding effect on investment
earnings. More volatile stocks have to work much harder
than less erratic stocks to restore the value lost during
periods of declines.

Investment risk can mean different things to different

people. In appreciating markets, investors typically focus
on the growth of their assets relative to the broader market.
In these environments, the risk that investors fear is that the
portfolio will not keep up with the market and that tracking
error or benchmark-relative volatility will not meet a
desired level. In declining markets, however, investors
become more concerned with the risks of capital impairment
and their inability to meet current and future liabilities. In
these environments, investors hope for a minimal level of
absolute volatility, expressed as the standard deviation of
returns, to help preserve their capital.

The structural changes that have taken place in the equity

markets in recent years as a result of the extensive
investment in exchange-traded funds is another factor that
should not be overlooked. There has been a dramatic
change in the past three years in the volume, availability and
usage of ETFs.
Traditionally, ETFs have been thought of as an easy way for
mutual funds and institutions to invest cash overnight or for
the short run because they have been considered cost
effective, transparent, tax efficient and an easy way to trade
intraday. Then large hedge funds especially macro hedge
funds utilized them to exploit opportunities. Hedge funds
are still factors in large short-term rotational shifts; however,
asset allocators now account for many of the short-term
swings in market volume, volatility and price movement,
largely because many of them have similar models.

Q: Are you suggesting that we need a paradigm shift for

investors to move into low-volatility investing?

Dino Davis: A paradigm shift is already underway in the

way in which investors have been moving out of equities
and into fixed income and also into alternative investments.
These asset allocation shifts have their limitations, however.
With low-volatility investing, you can make a shift within an
equity portfolio. At a high level, this is why the anomaly will
persist. The idea of relative benchmarks linked to specific
asset classes, styles and size buckets is woven into the very
fabric of investing. Trustees, for instance, evaluate managers
based on benchmark performance. There are trillions of
dollars invested on a relative basis and somewhere between
$100 and $200 billion invested in low-volatility products.
Even at the $200 billion level, there is much room for
movement into this strategy before the advantage is
arbitraged away.

One could also argue that volatility will persist as long as

Europe and the United States continue to grapple with
economic and fiscal challenges that are structural in nature
and without easy solutions.
In sum, the low-volatility anomaly is deeply rooted in the
structural and institutional fabric of the investment process
and will eventually disappear, but not for quite some time. If
one has a long time horizon, this is a major defensive
investment opportunity.

Unless otherwise indicated, logos and product and service names are trademarks of MFS and its affiliates and may be registered in certain countries.
The views expressed are those of the author(s) and are subject to change at any time. These views are for informational purposes only and should not be relied
upon as a recommendation to purchase any security or as a solicitation or investment advice from the Advisor.
Issued in the United States by MFS Institutional Advisors, Inc. (MFSI) and MFS Investment Management. Issued in Canada by MFS Investment Management
Canada Limited. No securities commission or similar regulatory authority in Canada has reviewed this communication. Issued in the United Kingdom by
MFS International (U.K.) Limited (MIL UK), a private limited company registered in England and Wales with the company number 03062718, and authorized
and regulated in the conduct of investment business by the U.K. Financial Conduct Authority. MIL UK, an indirect subsidiary of MFS, has its registered office
at Paternoster House, 65 St Pauls Churchyard, London, EC4M 8AB and provides products and investment services to institutional investors globally. Issued in
Hong Kong by MFS International (Hong Kong) Limited (MIL HK), a private limited company licensed and regulated by the Hong Kong Securities and Futures
Commission (the SFC). MIL HK is a wholly-owned, indirect subsidiary of Massachusetts Financial Services Company, a U.S.-based investment advisor and
fund sponsor registered with the U.S. Securities and Exchange Commission. MIL HK is approved to engage in dealing in securities and asset managementregulated activities and may provide certain investment services to professional investors as defined in the Securities and Futures Ordinance (SFO). Issued
in Singapore by MFS International Singapore Pte. Ltd., a private limited company licensed and regulated by the Monetary Authority of Singapore. Issued in Latin
America by MFS International Ltd. For investors in Australia: MFSI and MIL UK are exempt from the requirement to hold an Australian financial services license
under the Corporations Act 2001 in respect of the financial services they provide. In Australia and New Zealand: MFSI is regulated by the U.S. Securities and
Exchange Commission under U.S. laws, and MIL UK is regulated by the U.K. Financial Conduct Authority under U.K. laws, which differ from Australian and
New Zealand laws.
MFSE-LVREV-WP-6/14
27797.4