Less risk = more return
The most basic building block of modern academic finance is arguably that higher returns are a reward for taking greater risk. That is why stocks in the long run generate greater returns than less riskier investments such as corporate bonds, and why small entrepreneurial companies that strike it big deliver far more for shareholders than regulated utilities.
The problem with this theory is that it does not work. As academics sift through the data for persistent anomalies that can predict which stocks will perform best, the clearest is that lower risk stocks tend to outperform in the long run. There is a relationship between risk and return, in other words, but that relationship runs in exactly the opposite direction to the way that we had all supposed.
Since the financial crisis, there has been growing interest in low- or minimum-volatility strategies known as “Betting Against Beta.” The idea has been turned into indexes that underpin a range of different exchange-traded funds, and it is being applied by plenty of active quant managers.
To an extent, as is often the case with anomalies, the attempt to exploit this one started just as it stopped performing as well as it had in the past. This might be causal; if people think there is easy money to be made, they will pile into low-volatility stocks and thereby reduce the returns to be made. The strategy also had evident appeal in the aftermath of a major market bust. On such occasions, it strongly outperforms the rest of the market. When things are healthier, it tends to lag behind, but not by enough to eliminate its accumulated outperformance. The following chart shows the performance of MSCI’s U.S. minimum volatility index relative to the S&P 500 Index on a total return basis, with the CBOE VIX index of volatility on a separate axis:
As might be expected, low-volatility stocks with the least sensitivity to the broader market have their moment of glory when the market as a whole is in a seizure, as happened in 2000 and 2008. And since the worst of the crisis, the MSCI index has performed in line with the S&P 500, with troughs during times of calm and recoveries during market scares.
...But even if low-vol enjoys its best moments at times of turbulence, there does seem to be something persistent there. That is the finding of a new paper availablehere called “The Volatility Effect Revisited,” by David Blitz, Pim van Vliet and Guido Baltussen of the Dutch group Robeco Asset Management. They found high “beta” stocks – or those that are most sensitive to broader moves in the market and most volatile – did worst, while those that opted for the least variable suffered almost no loss of return. As lower volatility makes life far easier, this suggests that low-volatility stocks have powerful attractions. In this chart, based on data from the Kenneth French data library at Dartmouth University’s Tuck School of Business, we can see that over the last 55 years there has been minimal penalty for holding boring stocks, and quite a severe penalty for holding the more volatile ones:
This is not just a U.S. phenomenon. The authors cite the following chart, based on data from AQR, the U.S.-based fund manager, showing that the strategy of “betting against beta,” or choosing the stocks that are least sensitive to the market. The strategy has made money everywhere for which the data has been tested, and in most countries a low-risk strategy has done better than it has done in the U.S.
...And there is even evidence that the behavior of investment institutions, desperate not to look bad compared to their peers, has also tended to strengthen the low-volatility anomaly over time.
So, it turns out, the traditional approach of buying “widows and orphans” stocks in big, boring companies and holding them forever may have been a great idea after all. Who would have thought?
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