10 low-volatility shares are a safer option for your ISA

With global stock markets witnessing a sharp uptick in volatility, stock screen expert Ben Hobson has identified some ideas for investors wanting fewer sleepless nights.

There are just a few weeks left to take up this year’s annual ‘use it or lose it’ £20,000 ISA allowance. And with the new tax year on the horizon, a whole new allowance will soon be available.

But if you’re pondering where to deploy your tax-protected funds, you’d be forgiven for feeling a sense of unease. So far in 2023 there haven’t been any clear answers to the questions that dogged markets for much of last year.

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Sticky inflation, rising rates and a spluttering economy have left share prices feeling decidedly choppy. Throw in the spectre of bank runs in the US, and you can see why investors are feeling unnerved.

But while some shares have suffered in these conditions, others have been much more resilient.

Among them is a style of share that many investors don’t get excited about in good times. But research shows that they are not only more dependable in bear markets, but they are actually pretty good in bull markets too.

They are known as ‘low-volatility’ shares - and they offer a slightly different way of looking for more predictable returns this ISA season.

Getting to the bottom of risk and volatility

Look up ‘risk’ in the dictionary and the definition will say something like: “the possibility of something bad happening”.

In investing, there are plenty of people who see risk the same way. Famous investors such as Warren Buffett have described it as “the risk of permanent loss of capital”.

But in financial textbooks, the definition of risk is more subtle. It’s a measure of the difference between what you expect to happen and what can actually happen.In other words, the higher the risk the wider the range of potential outcomes, both good and bad.

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While there is no single measure of risk, academics have found measures that can hint at how a share might be expected to behave over time. One of them is called volatility.

Volatility is a measure of how much a share price (or even a whole market) swings up and down compared to its average over time. Bigger movements mean higher volatility.

High volatility doesn’t always mean higher risk, but it can be a pointer to shares that are less predictable. Crucially, higher volatility shares often attract speculative investors who interpret higher volatility as a signal of potentially higher future returns.

But this is where research into volatility has produced some surprising findings.

Profiting from the low-volatility anomaly

In 1975, a professor called Robert Haugen discovered the anomaly that low-volatility strategies actually outperform.

He found that investors (including professionals) were attracted by higher volatility shares as a source of alpha. But this pushed up their prices and stymied their returns.

By contrast, Haugen found that lower volatility shares can be cheaper and more predictable. This means that while they are slower to rise in strong markets they don’t fall as far in periods of turmoil.

More recent studies have found exactly the same thing. Research by Pim Van Vliet, an analyst at asset management firm Robeco, has shown that a low-risk, low-volatility approach delivers similar or better returns than the market across major stock markets, industries and conditions.

His research also shows that it is possible to introduce other factors such as value and momentum to achieve stable, above-average returns.

How to find low-volatility shares

To explore how volatility can be used to find shares, I have taken the FTSE All-Share and filtered it using two common risk measures plus a momentum signal:

• Beta (which measures a share’s price movements relative to the whole market). The Beta of the market itself is ‘1’, so any share with a Beta below ‘1’ has a history of being less sensitive than the market
• The list is sorted based on standard deviation (which measures a share’s price movements relative to itself) based on monthly volatility over five years
• The momentum measure is 1-year relative price strength, which will focus on shares that have performed better than the FTSE All Share in that time​​

Source: SharePad

The FTSE All-Share Index covers the largest 600 quoted companies in London, which takes in the FTSE 100, 250 and SmallCap indices. As this list shows, a focus on low volatility, as measured by standard deviation, tends to pick up shares at the large-cap end of that range.

Companies such as Unilever (LSE:ULVR), AstraZeneca (LSE:AZN) and SSE (LSE:SSE)are among the largest in the market. But like several others in the list they also operate in defensive sectors such as consumer staples, healthcare and utilities.

These large-cap defensives are in a sweet spot for low volatility, where you tend to find more predictable businesses that are well financed and able to resist economic headwinds. In tough times they can hold up well, but in bullish conditions they tend to be ignored by speculative investors looking for explosive returns.

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Because volatility is generally measured over the medium term, low-volatility shares tend to stay low volatility, so this isn’t a strategy that sees lots of chopping and changing. However, volatility is only one factor in the decision to buy a share. So mixing it up with other criteria, like the quality of the business, the attractiveness of its valuation or the positive trend in its price are all factors to consider.

With ISA season this year coinciding with rippling uncertainties about the strength of the economy and stresses in sectors such as banking and finance, it could pay to explore ways of defending against high volatility. Research shows that steering clear of speculative shares doesn’t mean compromising on expected future returns. On the contrary, a focus on low volatility could offer a sound base to perform well in any market environment.

Ben Hobson is a freelance contributor and not a direct employee of interactive investor.