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September 09, 2014 at 10:39 AM
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.
