• We introduce a simple analytic toolkit to assess the performance of factor indices compared to their cap-weighted parents. The methodology attributes a factor index’s excess returns to its incremental (or decremental) level of risk and to a changed tradeoff between risk and return.
• The low volatility "anomaly,” as defined by an improved tradeoff between risk and return, not only exists, but has strengthened in the past six years.
• More broadly, this toolkit can be used to assess the existence and persistence of any factor-based effect.
Classical economic theory tells us that risk and return are directly related— in general, in order to earn above-average returns an investor must be prepared to bear above-average risks. Empirically, however, this relationship does not hold; ample research and evidence point to the existence of a low volatility factor comparable to other factors such as beta, small size, or cheap valuation. Because this seems to fly in the face of what we think we know about risk and return, the low volatility factor is often referred to as the low volatility anomaly.
Exhibit 1 shows that the S&P 500® Low Volatility Index (including backtested history) outperformed its parent S&P 500 between 1991 and 2015, despite exhibiting lower risk.