Wednesday, March 9, 2011

Why do low volatility portfolios perform so well in practice? Some financial explanations

This blog is devoted to study the financial performance of low volatility investments, mainly from a statistical point of view. But in this post, I will show some financial explanations to this performance.
Because I am not an expert in Finance, I have collected some good explanations from the financial literature, which can be found at the end of this post. If you have more explanations, I will be very pleased to add them to this post.
Some years ago, I started to study low volatility portfolios from a statistical point of view: In the Markowitz framework, because there is too much estimation error in the expected asset returns, it is desirable to focus only on the variances and correlations of the returns. My surprise was that these portfolios were more efficient (ex-post) than portfolios trying to optimize (ex-ante) the trade-off between risk and return.
Moreover, this good performance is maintained when comparing to broad market indexes. Hence, the performance of low volatility portfolios indicates some type of anomaly in the financial markets. But why does it occur?
Of course, we can say this anomaly occurs because the financial markets are not perfectly efficient all the time. That is, risk and return at the stock level are not highly correlated in practice. Indeed, there exists evidence of stock portfolios that not always exhibit a significant positive correlation between risk and return.

But the question still remains: why do low volatility portfolios perform so well in practice?

I have read several papers and it seems there is no consensus about the origin of this inefficiency. But I show you some of the main explanations I have found (see the corresponding articles at the end of the post):

  • Investors price individual securities within an asset class the same (for example, large cap stocks or value stocks), instead of pricing the associated portfolio.
  • There exists higher demand for high volatility stocks. This is a consequence of an over-optimistic regarding high volatility stocks (hoping for high returns).
  • Portfolio managers mainly focus on tracking error, rather than total portfolio volatility.
  • Investors usually have leverage restrictions, and the good returns of low volatility investments cannot be easily arbitraged away.
  • Low volatility stocks are associated with a yet hidden risk factor, for instance similar to those proposed by Fama and French.
  • In a multi-period setting and over the long run, the average return of high volatility portfolios compounds slower than the return of low volatility ones.

Do you have any other explanation? I will be very pleased to add them to this post.
Finally, here is a selection of the literature I have read about this topic:

The Cross-Section of Volatility and Expected Returns by Ang, Hodrick, Xing and Zhang, in the Journal of Finance, 2006.

Minimum-Variance Portfolios in the U.S. Equity Market by Clarke, de Silva, and Thorley, in the Journal of Portfolio Management, 2006.

The volatility effect: lower risk without lower return by Blitz and van Vliet, Journal of Portfolio Management, 2007

A New Look at Minimum Variance Investing by B. Scherer, in the SSRN, 2010.

Risk and Return in General: Theory and Evidence by Falkenstein, in the SSRN, 2010.

Benchmarks as Limits to Arbitrage: Understanding the Low-Volatility Anomaly  by Baker, Bradley, and Wurgler, in Financial Analysts Journal, 2011.


  1. Another reason for low Vol performance is it can (I would argue does) avoid bubbles. As the S&P 500 index (market cap weighted) becomes more and more exposed to stock bubbles, low vol portfolios (based on risk) do not. Thus they are not overly exposed to 'downside' volatility. See the recent article from GSAM in the 401k Investment Lineup Summit insert to the Feb. 21, 2011 issue of "Pensions & Investments" put out by

    I do NOT work for plonline nor Goldman. But I do run Low Vol Portfolios. Now only if I could speak fluent Spanish and follow your tweets.

  2. David, thanks for the comment.

    I hope your low-vol portfolios are performing as good as the portfolios shown in this blog.