Low volatility strategies have garnered a fair amount of popularity and a growing body of supporting research. Studies have shown risk reduction levels of 25%, while turnover has varied from 20% to 120%. However, higher turnover produces higher costs of trading, such that the excess return obtained with low volatility products may actually be subsumed by those same trading costs. The authors of this study ask how much trading is needed to build and maintain a low volatility product.
Turnover beyond a value of 32% per year, perhaps to satisfy a desire to justify fees or demonstrate investment skill, is inadvisable. The evidence presented here suggests that it may instead be a signal of an inefficient portfolio construction process for single factor-low volatility portfolios.
However, there are valid reasons for a manager to increase turnover in a low volatility strategy in order to integrate other factors.
So stay tuned for Part 2: Turnover related to the integration of Value + Momentum + Low Volatility exposures.
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The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged and do not reflect management or trading fees, and one cannot invest directly in an index.
An efficient low-volatility strategy only needs a little amount of trading. The empirical literature on low-volatility investing reveals a concave relation between the amount of trading and the risk reduction. Portfolio simulations confirm this non-linear pattern in which each increase in turnover results in smaller marginal reductions in volatility. In general a moderate trading level of 30% is enough to reduce portfolio volatility by 25% compared with the market index. In addition, low-volatility stocks are relatively liquid and cheap to trade, primarily because they are much larger than the average stock. The law of diminishing returns also applies to other alpha factors such as value and momentum and integrating them into a multi-factor low-volatility strategy is an efficient way to increase factor exposure at low trading costs.
Low Volatility Can Be Low Turnover was originally published at Alpha Architect. Please read the Alpha Architect disclosures at your convenience.