In my latest book, “Your Complete Guide to Factor-Based Investing,” co-authored with Andrew Berkin, director of research at Bridgeway Capital Management, I explain that one of the big problems for the first formal capital asset pricing model (CAPM) developed by financial economists was that it predicted a positive relation between risk and return. But empirical studies have found the actual relation to be flat, or even negative.
Over the last 50 years, the most “defensive” (low-volatility, low-risk) stocks have delivered both higher returns and higher risk-adjusted returns than the most “aggressive” (high-volatility, high-risk) stocks. In addition, defensive strategies, at least those based on volatility, have delivered significant Fama-French three-factor and four-factor alphas.
The superior performance of low-volatility stocks was first documented in the literature in the 1970s—by Fischer Black (in 1972), among others—even before the size and value premiums were “discovered.” The low-volatility anomaly is pervasive, having been shown to exist in equity markets around the world, and it exists not only for stocks but for bonds.
Explaining The Anomaly
The academic literature provides us with several explanations for the low-volatility anomaly, which, by definition, must be attributable to a violation of one or more of CAPM’s underlying assumptions. While models can help us set prices and understand how markets work, by definition they are flawed or wrong—otherwise, they would be called laws, like we have in physics.
One of the assumptions of the CAPM is that there are no constraints on leverage or short-selling. In the real world, many investors are either constrained by the use of leverage (by their charters) or have an aversion to its use. The same is true of short-selling (with the potential for unlimited losses and the risk of margin calls), and the borrowing costs for some hard-to-borrow stocks can be quite high. Thus, because of short-selling constraints, high-risk stocks can become overpriced due to a phenomenon known as “the winner’s curse.”
In a market with little or no short selling, the demand for a particular security will come from the minority who hold the most optimistic expectations about it. As divergence of opinion tends to increase with risk, high-risk stocks are more likely to be overpriced than low-risk stocks because their owners have the greatest bias.
Another assumption of CAPM is that markets have no frictions, meaning there are no transaction costs or taxes. Of course, in the real world, there are costs. And the evidence shows that the most mispriced stocks are those with the highest costs of shorting.
Even regulatory constraints can be a cause of the anomaly, as regulators often don’t distinguish between different stock types, but merely consider the total amount invested in stocks for determining required solvency buffers. Investors who wish to maximize equity exposure but minimize the associated capital charge under such regulations are drawn to the high-volatility segment of the equity market because it effectively gives most equity exposure per unit of capital charge.