Balancing Risk with a Diversifying Low Volatility Exposure

  • Despite the dominance of growth stocks in the past decade, low volatility exposure has provided strong relative risk-adjusted performance, especially during down market months.
  • Investors who expect the reflation trade to continue on positive earnings and inflation expectations can look to complement a portfolio with downside protection.
  • In addition to strong low volatility exposure, the index tracked by our low volatility ETF aims to offer diversification* from large cap (size) and a strong yield following the August 2021 rebalance.

Growth-dominant sectors (e.g. technology, communication services and consumer discretionary) and the FAANG stocks in particular have led the S&P 500 Index to its current all-time highs. Despite these relatively high volatility companies leading the market on a nominal basis, low volatility stocks have still provided strong relative risk-adjusted performance since the launch of the S&P Low Volatility Index in April 2011, as evidenced by the strong Sharpe ratio of 1.06 (see Figure 1). 

Figure 1: Risk Return Comparison 


We see this result because the relationship between excess performance of the S&P Low Volatility Index and the nominal performance of the S&P 500 is negative (see Figure 2). This means that low volatility stocks tend to outperform, on average, in markets where the S&P 500 trades lower. The relationship creates an opportunity for investors to build a degree of protection into portfolios through diversification.

Figure 2: Monthly US Low Volatility Active Return vs. Market Return


The asymmetric relationship of relative returns is not the only diversification opportunity for investors in low volatility. Following the August 2021 rebalance, the S&P Low Volatility Index offers significantly low size exposure (i.e. stocks with smaller market capitalisation) and significantly high dividend yield exposure (see Figure 3).

Figure 3: FaCS Active Exposure Comparison (vs. S&P® 500 Index)


How to play this theme

Within US equities, we believe investors focused on medium to longer-term volatility may benefit from the diversification of a strategic investment to low volatility. SPDR® offers a suite of low volatility strategies that follow a simple yet effective methodology. In one trade, investors can introduce a defensive posture to their equity allocations using the SPDR® S&P® 500 Low Volatility UCITS ETF or a similar exposure in eurozone or global equities. To learn more about this ETF, and to view performance history, please follow visit the fund page.