Why Low Volatility Produces High Returns

Research Affiliates analysts examine the research that explains the persistence of outperformance by lower-risk stocks

They say there’s no such thing as a free lunch in economics.

But investing in low volatility stocks appears to make a gourmet banquet available at diner prices — with most of the tab picked up by investors eager to pay up for higher-priced high-vol stocks.

That is the implication of an analysis by Research Affiliates’ Feifei Li and Philip Lawton in the smart beta firm’s latest newsletter.

While investors generally believe that one must take on higher risk to achieve higher returns, Li and Lawton show that, to the contrary, the outperformance of low-volatility stocks has persisted both over time periods and across global markets.

U.S. low-volatility stocks — colloquially, the value stocks that tend to trade at a discount to the broad market (and even more so to high-volatility stocks) — exceeded the performance of cap-weighted benchmarks by more than 2 percentage points from 1967 to 2012, though the benchmark was more than 3 percentage points more volatile.

Looking at all developed markets from 1987 to 2012, low-vol’s premium was over 3 percentage points, though the benchmark was, again, over 3 percentage points more volatile.

In emerging markets between 2002 and 2012, low vol trounced the benchmark by between 7 and 9 percentage points (using two different low-vol formulations), though the cap-weighted benchmark was more than 7 percentage points more volatile.

Despite the persistence and seeming universality of the low-vol effect, the Research Affiliates duo prefer not to assume as an article of faith that the anomaly will continue without seeking to understand why it exists—i.e., why investors don’t “eradicate the return premium once and for all” by scooping up these stocks.

Since researchers have all but given up on resolving the anomaly within the “traditional framework of rational, utility-maximizing decision-making,” Li and Lawton cite behavioral finance studies to explain why investors would make “self-defeating investment decisions.”

One such explanation describes the attractiveness of “lottery-like risk” in pursuit of high returns.

“Investors with a strong penchant for gambling are likely to choose high-risk stocks with large potential payoffs over low-risk stocks with unexciting expected returns,” the authors write, noting that such a behavior pattern “would tend to produce the low volatility effect.”

Li and Lawton provide a subtler version of this gambling thesis by citing research theorizing that some investors are unwilling or unable to use leverage — they follow investment guidelines prohibiting borrowing, they lack access to low-cost credit or they consider borrowing too risky.

For investors such as these, risky stocks provide an outlet for the possibility of achieving high returns.

Another behavioral explanation involves the incentives of investment professionals subject to benchmark risk, business risk or career risk should they accumulate “loser stocks” that have recently fallen in price.

The benchmark risk occurs because the cap-weighted indexes that serve as benchmarks inherently favor popular stocks.

And since “clients typically ‘de-select’ managers who underperform the benchmark for three years,” the authors write, investment professionals risk “losing clients, bonuses, and ultimately their job” if they do not cling to their benchmark. This sort of closet-indexing, like the penchant for gambling, would tend to reinforce the low -olatility effect.

Conversely, Li and Lawton cite empirical evidence that sell-side analysts exaggerate the virtues of growth stocks, which would contribute to the market’s overvaluing high-volatility stocks.

Citing the success of smart-beta low volatility since the global financial crisis, the Research Affiliates duo add that investors have mechanisms by which they reaffirm their false faith in their failed approaches rather than avail themselves of the excess returns of low-vol.

They cite research indicating that “managers characteristically tell stories to explain their successes and failures,” the former using the “epic genre,” the latter using the “tragic genre.”

The plausibility of these rationalization have the effect of protecting their investment beliefs and keeping them from learning from their mistakes.

For all these reasons, Li and Lawton “expect low-volatility investing to persist in producing excess returns,” noting research suggesting that gambling (i.e., “chasing outlier returns”) is considered a behavioral addiction.

Similarly, activities that go hand in hand with the quest for high returns such as active management and its attendant high fees aren’t going away, either, thus leaving ample room for contrarian investors to benefit from low volatility and high returns.

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