Monday, 16 July 2018

The low-vol anomaly, or doing well out of others' mistakes

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  • James Saft - June 2014

James Saft on why one can do better by taking less volatility.

Sometimes in life you really can get more for less, but usually only when someone else is a) acting foolishly, or b) taking advantage of a client.

So it appears to be with the low-volatility anomaly, a persistent and puzzling phenomenon under which lower-volatility stocks, which in theory should offer lower returns, actually outpace their higher-vol peers. This of course flies in the face of mainline theories of modern finance, which assume that assets are priced, in aggregate, based on how risky they are and which assumes volatility as the prime measure of risk.

Except, when you look at the data, that is not actually how it works. Among the 1,000 largest US stocks by capitalization between 1967 and 2012, the bottom fifth in volatility returned an annualized 11.65%, as against just 9.81% for a cap-weighted index, according to data from asset allocation specialists Research Affiliates. Among global stocks from 1987–2012 the corresponding figures were 10.58% for low-volatility shares against 7.58% for the index.

So why can you do better by taking on less volatility? Remember, though volatility isn’t a perfect substitute for risk it is undeniably expensive and dangerous. Your risk of being found short of available assets in a pinch is just one reason why.

As usual, the answer is that people do stupid stuff, either on their own behalf or at the expense of others. Actually the list of reasons, many behavioral, reads like a laundry list of the shortcomings of the financial markets, its participants and how they interact with clients.

“A simple, direct explanation of the low-volatility effect is that many investors willingly accept lottery-like risk in pursuit of better-than-average returns. In other words, many investors are given to gambling,” Feifei Li and Philip Lawton or Research Affiliates write in a note to clients.

“A more subtle behavioral explanation of the preference for risky stocks is grounded in textbook finance. Risky stocks offer an outlet for leverage-constrained or leverage-averse investors who seek high returns.”

Career risk is (too often) paramount

Investors, seeking to strike it lucky with a hot momentum stock (Alibaba, anyone?), pay up for higher-volatility shares, thereby reducing future returns. It should come as no surprise then that there is a large and statistically meaningful overlap between low-volatility shares and value and small cap stocks. This is a simple demonstration of the cost of chasing the newest big thing, as opposed to buying value at a good price.

So it is with constrained investors, such as those who work for pension or mutual funds which can’t use leverage. They pile into more-volatile highly leveraged companies as a back-door way to achieve leverage and goose returns. While it must work for somebody, the aggregate data is not encouraging.

Some investigators, notably a 2013 study from Research Affiliates and Nomura, have also theorized that some of the low-volatility phenomenon is due to the influence of sell-side research. Sell-side analysts are historically hugely optimistic, always over-estimating earnings. This in turn drives both volatility and “systematic over-valuation” among the stocks covered, which again reduces future returns. You need only look back to the dotcom bubble to see how this works. Analysts cheerlead, investors plunge money on stocks in reaction and over-pricing and lower long-term returns result.

Another force driving low-vol outperformance is investment professionals who worry about their own career prospects over, well, over what they are paid to do. Managers engage in window dressing, shunning stocks which have recently dropped in price and bunching up in stocks which have done well.

Managers also act as ‘closet-indexers’, buying stocks largely in proportion to their weights in the indices in order to minimize their risk of underperforming and getting fired. Of course as larger-cap, often momentum stocks dominate the index, this tendency interacts with and magnifies the momentum effect discussed above.

The crucial question is: can this state of affairs persist? After all, the low-vol effect is well known and has been studied for decades. There is no shortage of strategies available to investors wanting to take advantage of it, which in theory should arbitrage some of the outperformance away.

Li and Lawton argue, in effect, that it can last because people simply don’t learn that well, choosing instead to rationalize or ignore their underperformance or self-dealing.

I have to hold out a bit more hope, at least when it comes to improving incentives for money managers.

In the meantime, though, you’d be forgiven for just being thankful for other people’s folly.

(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication he did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at

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