The Low-Volatility Anomaly in Switzerland put to the test

The low-volatility anomaly is one of the most exciting phenomena in empirical capital market research and is at the heart of defensive quantitative investment strategies. The anomaly is referred to as such because - contrary to the capital asset pricing model - low-risk stocks on average generate higher returns than high-risk stocks. The exact measure of risk is of secondary importance here, so in addition to volatility - i.e. the range of fluctuation of a stock - market beta is often used, i.e. how much the stock fluctuates in step with the market. Optimized risk-based portfolios, such as our minimum variance solutions, are closely related to this effect, as they overweight low-risk stocks and avoid high-risk stocks.

While academic studies on the low-volatility anomaly mostly refer to the U.S. equity market, the number of studies on the Swiss market is much lower. Although risk-optimized investment solutions are also very popular here, there have been questions during the bull market of recent years as to whether the low-volatility anomaly is still present in Switzerland. An argument often put forward is that the Swiss market as a whole is rather low-risk, so therefore it might not be worthwhile to focus on low-volatility stocks. We want to clarify these issues and also recapitulate the last years and the current market situation.

The Procedure

We sort the most liquid stocks¹ of the Swiss Performance Index (SPI) by their historical 52-week volatility and build a simple low-volatility portfolio by investing in the third of stocks with the lowest volatility. All stocks within the low-volatility portfolio are equally weighted and updated once per quarter. Similarly, the high-volatility portfolio consists of the third of the SPI stocks with the highest volatility. The mid-volatility portfolio consists of the middle third. In addition, we construct a long-short low-volatility portfolio by taking a long position in the low-volatility stocks and a short position in the high-volatility stocks².  

The Long-term Perspective

Our analysis starts on January 01, 2007 and ends on April 30, 2022. Figure 1 shows the performance over this time horizon. The simple low-volatility Portfolio achieves a significantly higher return (+232.7%) than the SPI benchmark ( +125.2%) and the Mid-Volatility Portfolio (+139.1%). Although the portfolio with the riskiest stocks repeatedly outperforms in phases of friendly equity markets - as happened in the market recoveries after the global financial crisis in 2008/09 and after the Corona slump in spring 2020 - it is by far the weakest performer over the long term (+40.6%).

If we consider not only purely returns, but also the portfolio volatility and the level of losses incurred, the result is even more clearly in favor of low-volatility: As seen in Table 1, the risk-adjusted return - as measured by the Sharpe ratio - increases steadily from high- to low-volatility stocks. This pattern is highly robust to details of volatility portfolio construction. Thus, the risk-return trade-off is clearly most favorable for defensive stock selections. This confirms the existence of the low-volatility anomaly also in the Swiss equity market and shows how investors can benefit from it through a long-only portfolio.

Corona, Interest Rate Fears and the Ukraine War

At the start of the Corona crisis in February 2020, global equity markets suffered a severe and very rapid drop, followed by an equally sharp rise in markets, aptly called a V-shaped recovery. The performance of volatility portfolios during this phase is highlighted in Figure 2. In the downward movement, the low-volatility portfolio achieved only a slight reduction in losses versus the SPI, as the three index heavyweights Nestlé, Roche and Novartis had a stabilizing effect on the capital-weighted SPI here. The mid- and high-volatility portfolios suffered much higher losses, again reflecting the benefits of defensive stock selection. Although low-risk stocks fell behind the riskier stocks during the strong recovery phase, the tide turned again recently. Since fall 2021, inflation and interest rate concerns have weighed on global equity indices. Added to this, since February 24, 2022, has been the Russian invasion of Ukraine and the accompanying sanctions imposed by Western countries. In this current phase of greatly increased uncertainty, the benefits of a defensive investment strategy are once again evident: Since the beginning of 2022, the low-volatility portfolio has managed to limit losses significantly, while riskier stocks have suffered the most.

Long-Short Low-Volatility

We now want to take a look at the long-short low-volatility portfolio. While this portfolio is not feasible for many investors because it requires short selling, this strategy offers interesting insights into the low-volatility anomaly and is therefore the focus of most academic work. Figure 3 shows the cumulative return of this portfolio since January 1, 2007. It can be clearly seen that although the low-volatility premium is positive, it is subject to large fluctuations over time. This market neutral portfolio achieves a positive return during turbulent market periods, such as the financial crisis, the Euro crisis, the attempt to tighten monetary policy in 2018, or most recently with flare-ups of the Ukraine conflict. Over the entire period since January 1, 2007, the average annual return of the long-short portfolio is 1.4% and has continued to increase in recent years: over the past approximately five years (since January 1, 2017), the long-short portfolio achieved an average of even 4.3%. Since the beginning of 2022, the Low-Volatility Portfolio has been able to benefit strongly from the general risk-off dynamics of the markets and has achieved a return of +23.2% (as of 11.05.2022).

Conclusion

In summary, we find that the low-volatility anomaly continues to be present in the Swiss equity market and has not weakened in recent years - on the contrary. A low-volatility portfolio continues to promise higher risk-adjusted returns than the cap-weighted market over the medium to longer term, offering investors an attractive alternative to the inefficient and cluster-risk-laden SPI. Why the comparison of returns with the Big-3-heavy SPI as a benchmark is problematic, and what influence midcap stocks have on our Equity Switzerland fund, you can read in our next Research Blog.