The low volatility style factor - A great history, but can it continue?

Low volatility has been the darling of the style factor investment world and for good reason. Who doesn't want lower risk and higher returns? It has been a free lunch that should not exist. Low volatility factor strategies have consistently had higher information ratios than a corresponding benchmark index. The return to risk advantage exists across geography and styles. Reduce risk and gain return through a focus on low volatility.

The strategy is simple with a sorting of risk across a universe of stocks and buying the low volatility names. It is not a minimum volatility strategy which is formed differently. A classic finance view would say that lower risk means lower return, but what has been found is that return to risk for this style factor is relatively high and persistent. 

Using low volatility is a simple asset allocation solution to providing some downside protection without high costs. The upside and downside capture analysis of low volatility indices shows that it captures about 70-80 percent of the upside for benchmark gains, but sees only a portion of the downside losses; less than 50 percent for down months. Lose less in down markets and capture more in up markets generates positive gains versus a benchmark. 

The question is whether this style can persist, or in the modern jargon, is this a crowded trade? The historical data says that it can. There are periods when both the market and rates rise which are not low volatility favorable, but generally, this factor shows consistency. There has been analysis that shows low volatility stocks are looking expensive, but the low volatility signals have existed for a few years. Even with the greater focus on this strategy, it is worth a closer investigation. 

Low volatility stocks have been and continue to be expensive; however, when compared against the market as a whole, the richness is not extraordinary versus the market in general. Clearly, the risk to all equities is higher and low volatility is sensitive to rising rates, but there is room for switching to low volatility exposures as a way of taking risk off the table while still participating in the equity markey moves.