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.
One explanation for the low-volatility anomaly, then, is that faced with constraints, frictions and fears of the risks of short-selling, investors looking to increase their return choose to tilt their portfolios toward high-beta securities to garner more of the equity risk premium. This extra demand for high-beta securities, and reduced demand for low-beta securities, may explain the flat (or even inverted) relationship between risk and expected return relative to the predictions of the CAPM model.
Do Hedge Funds Exploit The Low-Vol Anomaly?
The latest contribution to the literature on the low-volatility anomaly comes from David Blitz in his January 2017 paper, “Are Hedge Funds on the Other Side of the Low-Volatility Trade?” His study covered the 10-year period 2006 through 2015.
Hedge funds are thought of as typically for sophisticated, “smart money” investors, who are usually not hindered by the aforementioned constraints. Thus, they would be able to not only benefit from the anomaly but also be positioned to benefit from it.
Blitz did, in fact, find that “the return difference between low- and high-volatility stocks is indeed a highly significant explanatory factor for aggregate hedge fund returns.” However, he also found that the opposite was true: Surprisingly, hedge funds tend to bet against—not on—the low-volatility anomaly.
In fact, Blitz found that when the long and short sides of the low volatility factor were considered separately, not only did hedge funds have a significant bet against low-volatility stocks, they had a significant bet on high-volatility stocks, with the latter bet being more significant and resulting in a higher R-squared. Blitz noted that this finding was consistent with that of the 2015 paper, “Investing with Style” by Cliff Asness, Antti Ilmanen, Ronen Israel and Tobias Moskowitz. Asness et al. examined the exposure of hedge fund indices toward various factor premiums and noted that hedge funds exhibit a significant exposure toward high-risk stocks.
Another surprising finding from Blitz’s analysis is that hedge funds also had significantly negative exposure to the profitability factor, although the significance of this relation is much less strong than for the volatility factor, and R-squared levels are also lower.
Why Are Hedge Funds On The Wrong Side?
Given the sophisticated nature of hedge funds, an interesting question is: Why are they on the wrong side of the low-volatility (and profitability) trade? Nardin Baker and Robert Haugen, authors of the 2012 paper, “Low Risk Stocks Outperform within All Observable Markets of the World,” provide a likely explanation. The anomaly can be explained by the nature of manager compensation and agency issues: (a) between professional investment managers within an organization; and (b) between these professionals and their clients.
The authors write: “The conflict arises because a portfolio manager is typically paid a base salary, plus a bonus if performance is sufficiently high. This compensation arrangement resembles a call option on the portfolio return, the value of which can be increased by creating a more volatile portfolio.”
In other words, there is a conflict of interest between professional investors, who have an incentive to engage in risk-seeking behavior, and their clients, who are more likely to be risk-averse, as assumed by the CAPM.
Based on Blitz’s findings, we might conclude that the incentive structure of their compensation (typically 2%/20%) leads hedge funds to favor the same overpriced stocks that individual investors seem to prefer—those that resemble lottery tickets, which have a low probability of a high payment and low expected returns, despite the high risks. In their 2014 paper, “Explanations for the Volatility Effect: An Overview Based on the CAPM Assumptions,” David Blitz, Eric Falkenstein and Pim van Vliet support this hypothesis by arguing that the rewards of being recognized as a top manager are much larger than the rewards for second-quintile managers, for instance.
They write: “For example, top managers receive a disproportionate share of attention from outside investors, such as making it to the front cover of Bloomberg Markets magazine. In order to become a top investment manager, one must generate an extreme, outsized return. This has the additional benefit of signaling to potential future investors and employers that one is truly skilled, as it is virtually impossible to distinguish between skill and luck in a modest outperformance. Delegated portfolio managers focused on realizing an extreme return in the short run may be willing to accept a lower long-term expected return on the high-risk stocks which enable such returns.”
Questions come to mind about Blitz’s study. First, a 10-year period is relatively short. Conversely, however, the prior data contain many biases (such as survivorship bias) that the data providers have tried to address.
That’s one reason for using a relatively short period. Another issue is that his analysis is returns-based via regressions rather than holdings-based. Thus, we don’t have direct confirmation of hedge funds going long high-volatility stocks and short low-volatility stocks. It’s possible there is something else going on that manifests as a high-volatility bias. That is somewhat mitigated by the very high t-stats, in excess of four, that Blitz found.
Blitz drew the following conclusion from his findings: “This argues against limits to arbitrage such as leverage, short-selling and benchmark constraints being the main explanation for the low-volatility anomaly.”
That statement seems too strong. Just because some investors still seem to prefer, on average, high-volatility stocks (such as hedge funds with their greater flexibility) doesn’t mean there aren't many other investors who are constrained by limits to arbitrage.
Blitz also concluded that “the finding that hedge funds are betting against the low-volatility anomaly is also a strong counterargument against the concern of some investors that the anomaly has been largely arbitraged away already, or that it may have turned into an ‘overcrowded’ trade. These concerns are driven by the rising valuations of low-volatility strategies and rising assets under management in both active and passive low-volatility strategies. However, the finding that the multi-trillion hedge fund industry is, on balance, strongly betting on high-volatility stocks suggests that this large group of investors is on the other side of the low-volatility trade. So much smart money betting against the low-volatility anomaly makes it seem unlikely that the anomaly is close to having been arbitraged away or has turned into an overcrowded trade.”
Another conclusion one might draw is that hedge funds betting against low-volatility stocks and betting on high-volatility stocks is another factor that helps explain their very poor performance. For the 10-year period 2007 through 2016, the HFRX Global Hedge Fund Index lost 0.6% per year, underperforming every single major equity and bond asset class.
As shown in the table below, the underperformance ranged from 0.4 percentage points when compared to the MSCI EAFE Value Index to as much as 8.8 percentage points when compared to U.S small-cap stocks.
Perhaps even more shocking is that, over this period, the only year that the hedge fund index outperformed the S&P 500 was 2008. Even worse, when compared to a balanced portfolio allocated 60% to the S&P 500 Index and 40% to the Barclays Government/Credit Bond Index, it underperformed every single year.
In summary, Blitz’s findings are particularly interesting because they seem totally contrary to what we would expect from hedge fund investors. And it does seem that the best explanation for the strange behavior is the misalignment of interests created by the incentive compensation structure. It’s just another reason to avoid investing in hedge funds.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.