When low-volatility strategies were first introduced, they seemed almost too good to be true. These strategies answered a common desire of institutional investors: having the returns of the equity market but not the volatility.
At first, investors were skeptical of low-volatility strategies as they felt like alchemy: they appeared to undermine traditional investment theory, which states there can be no return without commensurate risk.
But when these strategies demonstrated they could indeed deliver equity-like returns with about two-thirds of market volatility, investors became convinced and the strategies' popularity grew.
In fact, low-volatility strategies fared better than many investors expected, exceeding equity returns while maintaining their volatility targets. In addition, these returns could be achieved cheaply by opting for passive products that replicated rules-based low-volatility indexes such as the MSCI Minimum Volatility index.
The combination of desirable risk/return characteristics along with cheap implementation made low-volatility exchange-traded funds and passive funds some of the best-selling financial products in recent years.
But they are not without risk.
Low-volatility indexes are constructed using relatively straightforward techniques. Typically, index providers simply aggregate the least volatile stocks in the cap-weighted index, while controlling for country and sector weights.
This approach might not help an investor avoid potential pitfalls, such as interest-rate risk, concentration risk or valuation risk. While these risks have created a nice tailwind in the past, it seems inevitable they will reverse at some stage.
Going forward, investors should think carefully about the approach they take to low-volatility investing.