The Low Volatility Edge
One of the main takeaways from our recent Quantamentals course is that combining different edges together leads to greatly enhanced trading and investment results.
In our course, we specifically combined historical edges from Fundamental, Technical and Quantitative analysis to build high performing portfolios.
This stacking of edges ultimately led to portfolios with double-digit returns and single-digit drawdowns over the last 16+ years.
In this edition of the Connors Research Trader’s Journal, we will cover one of the edges we utilize in the models we built in the course – the low volatility edge.
What is the Low Volatility Edge?
The low volatility edge is the empirical observation that “defensive” stocks (low-volatility, low-risk) have delivered both higher returns and higher risk-adjusted returns compared to “aggressive” stocks (high-volatility, high-risk).
This is a large blow to the original academic pricing model – the capital asset pricing model (CAPM). CAPM states that there is a positive relationship between risk and return, as a “rational” investor should demand a higher return to compensate for accepting more risk.
Not only does this not hold up in the real world, but the empirical results are in fact the opposite – low volatility (risk) stocks tend to lead to higher returns. The outperformance is even more dramatic when returns are viewed on a risk-adjusted basis.
Academic Evidence
There have been several academic works that demonstrate this low volatility effect. One relatively recent academic work was the 2014 paper “Betting Against Beta,” written by Andrea Frazzini and Lasse Heje Pedersen.
https://pages.stern.nyu.edu/~lpederse/papers/BettingAgainstBeta.pdf
In the paper, the professors went long low volatility stocks and shorted high volatility stocks. This market neutral portfolio realized a Sharpe ratio of 0.78 from 1926 to 2012. Frazzini and Pedersen then expanded this research to not only include the US but investigated 10 international equity markets and found similar results.
Low Volatility Test
To inspect the low volatility edge, we will form a long-only portfolio of the 50 stocks with the highest and lowest historical volatility from the 500 most liquid stocks. The portfolio is rebalanced monthly from January 2003 to the end of September 2019.
We utilize a 200-day lookback of realized volatility. Volatility here is the trailing standard deviation of daily returns.
The spread between the least and most volatile stocks is dramatic. Not only do the lower volatility stocks produce significantly higher returns, they also do so with less volatility and drawdown, leading to a significant improvement in the Sharpe Ratio.
We can see that:
- Returns increased to 9.90% from 3.10%
- Volatility decreased to 11.4% from 33.9%
- Max Drawdown decreased to -37.10% from -78.70%
- Sharpe Ratio increased to 0.89 from 0.26
Stacking Edges Together Leads to Better Results!
To be clear, we are not advocating for you to just invest in low volatility stocks.
While low volatility stocks handily outperformed high volatility stocks as evidenced by the results above, simply applying just one edge isn’t optimal. Stacking additional edges found in fundamental analysis and technical analysis significantly improves performance.
Summary
The Low Volatility Edge is real when it comes to investing. Chasing high volatility stocks may be exciting for some people, especially those chasing action, but as you see from above, the better way to construct one’s portfolio is by first focusing on the stocks which have historically been more dependable.
Your Opportunity to Learn Quantamentals – The Next Great Forefront of Trading and Investing.
In our new Quantamentals Course, we taught how to combine Fundamental Analysis, Technical Analysis and Quantitative Analysis to produce investment models with double-digit returns with single-digit drawdowns from 2003- September 2019.
You will learn new trading strategies, new research, along with the ability to combine quantified and systematic momentum, mean reversion, and rotation strategies to your portfolio.
The Quantamentals Course Includes:
- Four 90-minute weekly classes taught by Larry Connors and Chris Cain, CMT teaching you everything you need to know about Quantamentals
- A number of new cutting edge, proprietary Quantamental Strategies
- Unlimited access to all the class recordings
- Full class materials for you to study over and over again
- Full know-how on how to professionally combine technical analysis with fundamental analysis along with quantitative analysis
- Daily Signal Code – Chris Cain’s Python code for the strategies taught, including the signal generation
- A Private FB Group where you will be interacting with Larry and Chris who will interact with you and answer your questions
Special Bonus: We will be holding a special follow up Quantamentals “class get together” in early January to assure you’ve mastered all the materials and have your Quantamental strategies in place to get 2020 off to a great start.
Who’s The Quantamentals Course For?
If you have a 6, 7 or 8 figure account and at least 3-5 years of trading experience, this course is for you. Also, everyone enrolled in the course will be signing a nondisclosure agreement (NDA) to assure the strategies stay private within the class.
Quantamentals is the next great forefront of trading and investing. Join the dozens of professional money managers and traders who have already enrolled in the course. To order the Quantamentals Course please click here.
New Book! – The Alpha Formula – Beat The Market With Less Risk by Chris Cain, CMT and Larry Connors
The passive investment industry states there is no Alpha in the markets. This book proves them wrong!
The Alpha Formula – Beat The Market With Less Risk teaches you strategies and portfolios with historical Alpha in Stocks, ETFs, and Fixed Income.
Backed by many quantified, systematic strategies, dozens of academic studies and combining behavioral finance with Ray Dalio’s correlation research, this book will teach you new, easy to understand quant strategies you can apply immediately.
To order The Alpha Formula – Beat The Market With Less Risk, please click here
Larry Connors & Chris Cain, CMT