Volatility as a Reliable Alpha Source

Topics: , ,

Published on February 20, 2019

| 3 min read

David Schofield, President, International Division

Share:

At Intech®, we harness natural stock-price volatility to generate an excess return above the benchmark – without forecasting returns. We find that a stock’s price volatility is more persistent than its return, making volatility a reliable input for portfolio construction.

To illustrate this point, we separate the stocks in the MSCI World Index into three equal-sized categories based on trailing one-year returns for each calendar year between 1992 and 2017. The “high return stocks” category includes the top third of performers in any given year, the “mid” category includes the third of performers with middling returns, and the “low” segment the bottom third of performers.

We then categorize the stocks similarly but instead, use trailing one-year volatilities (i.e., standard deviations). The high, mid and low segments are determined by the third of stocks exhibiting the most volatility, moderate volatility, and the least volatility, respectively.

Finally, we calculate the average percentage of each group that remained in the same category the following year. These results are shown in Figure 1.

 

Figure 1 The Stability of Volatility

 

Return characteristics prove to be highly variable, with only 30% to 35% of securities staying in the same category in any two consecutive years. In contrast, volatility characteristics are much more consistent. Indeed, high volatility stocks remain in the same category 61% of the time, and low volatility stocks 67% of the time – both at least twice the occurrence of their “return” counterparts.

Even the mid-volatility group, which remain in the same category only 46% of the time, is still notably more stable compared to the 35% of the time for the mid-return group. (It intuitively makes sense that the mid-volatility segment experiences more movement than high and low peers, as stocks have potential to shift either up or down, rather than in only one direction for the other categories.)

This less frequent movement of individual stocks between volatility categories results in a relatively reliable volatility hierarchy. That is, if one stock is more volatile than another, that relationship is likely to persist – independent of returns.

Is Volatility a Friend or a Foe? Learn more about volatility in our recent paper. Download Now

 

 

This information is intended to be educational and is not tailored to the investment needs of any specific investor, nor is it an endorsement or recommendation for any particular security or trading strategy. You should not rely on this information as the primary basis for your investment, financial, or tax planning decisions. Past performance cannot guarantee future results. Investing involves risk, including the possible loss of principal and fluctuation of value.