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Low volatility generates performance through market anomalies


Rewarded factors based on academic research are meant to show anomalies and opportunities within the equity markets, says Nick Kalivas (pictured), Senior Equity ETF Strategist at Invesco.

Examining the historical performance of the Invesco S&P 500 Low Volatility ETF (SPLV), an ETF that accesses the low volatility factor, typically you see more of an upside capture in a down market cycle.  However, since its inception in May 2011, SPLV has outperformed the S&P 500 by 0.98 per cent despite the fact that there has been a bull market for the past decade. And last month, when the S&P 500 fell 6.35 per cent, SPLV saw a decline of 0.96 per cent. 

Kalivas believes there is a robust relationship between the excess returns of the Invesco Low Vol Suite and the potential for a global economic slowdown shown in several economic indicators. The Invesco Low Vol Suite includes SPLV, Invesco S&P MidCap Low Volatility ETF (XMLV) and Invesco S&P SmallCap High Dividend Low Volatility ETF (XSLV). He also reveals that the backdrop of trade tensions and geopolitics have supported low volatility but that these dynamics have cycled with the rolling pessimism and optimism of a trade deal with China.

The reasons why low volatility generates its performance are many, Kalivas says. “One is essentially this idea that investors treat their stocks to some degree as lottery tickets, so when they invest they are looking for those companies that have strong growth prospects, and essentially ignore the more boring low volatility stocks.”

The second reason for the success of low volatility trading is leverage aversion. “There are structural impediments in place to cause investors who want a higher return to take higher risk by buying higher risk stocks to earn a higher return. The result is either crowding or over pricing of high risk and lower of low risk hence the anomaly develops so over time the lower risk stocks outperform.”

The third reason for low volatility’s success is a structural one, based on a market structure dynamic called limits to arbitrage. “The concept here is that large institutions, endowments and pension funds are paid by getting their return in the asset class so they want to own large equities,” Kalivas says. “They get paid by how well they track indices, but if they earn too much return the boards are saying ‘why did you take the risk?’ or if they underperform ‘what did you do to cause underperformance?'”

Kalivas says that as a result of that structure, a lot of institutional money managers invest close to the market portfolio and their low volatility sector exposures can vary dramatically.

“To exploit the low volatility anomaly, you would have to take sector bets, which institutions won’t do so the low volatility anomaly is not arbitrage,” he says.


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