Making Sense Of Low Volatility Investing

February 21, 2013

Low-vol strategies will likely result in greater diversification and more attractive final investor portfolios.

Robert A. Haugen, who passed away this month, found that stocks with lower price fluctuations tend to outperform riskier ones. This article summarizes several hypotheses advanced to explain the persistent low volatility anomaly, reviews the performance of low volatility strategies in up and down markets, and shows how adding a low volatility component can reshape a portfolio’s risk–return profile.

My heart was saddened when I learned that Professor Robert A. Haugen passed away Sunday, January 6, 2013. When given the opportunity to write this issue of Simply Stated, I could not resist calling out to our industry to remember and to pay homage to “the father of low volatility investing.” Bob was a respected scholar who spoke passionately about market inefficiency and the low volatility anomaly over the past half century. Together with Dr. James Heins, he discovered in the late 1960s and early 1970s that, contrary to the prevailing theory, low-risk stocks actually produce higher returns. As a researcher and a product specialist in low volatility strategies, I have often cited their seminal paper, Risk and the Rate of Return on Financial Assets: Some Old Wine in New Bottles (Haugen and Heins, 1975). I have also had the pleasure of speaking and corresponding with Dr. Haugen’s long-time associate, David Fallace, who shares his passion on topics related to low volatility. Dr. Haugen, according to David, cared deeply about educating investors and helping them make better decisions. I am saddened that I won’t have the opportunity to collaborate with Dr. Haugen on my low volatility research, but I know that his research and his passion will remain a significant influence on my work.

What Is Low Volatility Investing?
Now let’s review Dr. Haugen’s proposal carefully and understand why he was so dedicated to promoting low volatility investing. Stated simply, low volatility investing means putting your money in stocks with lower price fluctuations. The surprise is that, contrary to the axiom of financial theory that investors are rewarded for bearing risk, those low risk stocks tend to outperform their risky peers. The empirical evidence is clear and has been since the work done by Dr. Haugen in the 1970s. However the investment community only started to pursue low volatility investing in the aftermath of the Global Financial Crisis. MSCI entered the game in April 2008 by creating the MSCI Global Minimum Volatility Indices using an optimization approach. Since April 2011, the S&P 500 Index has launched a series of low volatility indexes, whose constituents are weighted in proportion to the inverse of their realized volatilities. (In other words, the lower the historical volatility, the higher the weight.) PowerShares S&P 500 Low Volatility ETF (SPLV), launched in May of 2011, is now the largest ETF in the category with $3.2 billion.

With institutional investors announcing low volatility mandates and initiating manager searches at an unprecedented pace, investment consultants have joined practitioner researchers in producing white papers and journal articles on the topic.

There are four complementary hypotheses on the low volatility anomaly:

  • The leverage aversion hypothesis holds that many investors who demand high returns are leverage constrained and choose to increase their expected returns by overallocating to high beta stocks, even if the latter have demonstrably lower Sharpe ratios. (See Black, Scholes, and Jensen, 1972; Frazzini and Pedersen, 2011.)
  • The preference-for-gambling hypothesis argues that investors irrationally use high volatility stocks as lotteries; in this framework, investors are implicitly willing to accept lower expected returns by paying a premium to gamble with high volatility stocks. (See Baker, Bradley, and Wurgler, 2011.)
  • Another plausible behavioral hypothesis attributes the anomaly to analysts’ optimism about more volatile stocks. Hsu, Kudoh, and Yamada (2012) find that analysts tend to produce high growth forecasts for high-volatility stocks; this can push up their prices and correspondingly reduce future returns.
  • Finally, the delegated-agency model provides an explanation for why the low volatility premium could persist even when professional money managers have been aware of the anomaly. The theory contends that most portfolio managers are benchmarked against a common core equity index; they are simply unwilling to buy low volatility stocks, which would significantly increase their tracking error against the benchmark. (See Brennan, Cheng, and Li, 2012; Baker, Bradley, and Wurgler, 2011.)

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