A major problem for the first formal asset pricing model developed by financial economists, the CAPM, is that while it predicts a positive relation between risk and return, 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.” Interestingly, the low-volatility anomaly has also been found to exist in equity markets around the globe, and not only for stocks but for bonds as well. In other words, it is pervasive.
While finance students are taught that expected return is a linear function of risk within most asset classes, highly risky assets have generated consistently lower returns than those with average risk, and after transaction costs are included, risky asset classes such as options have been poor investments. And the riskier the investment, the worse the result. Yet risky assets attract excessive interest from individual as well as institutional investors.
Publication of the findings on the low-volatility anomaly combined with the bear market caused by the financial crisis of 2008-2009 led to a dramatic increase in the popularity of low-volatility strategies.
As one example, as of April 2017, the iShares Edge MSCI Minimum Volatility USA ETF (USMV) had assets exceeding $12 billion, and the PowerShares S&P 500 Low Volatility ETF (SPLV) had assets exceeding $6 billion.
Explaining The Anomaly
Pim Van Vliet and Jan de Koning’s new book, “High Returns from Low Risk: A Remarkable Stock Market Paradox,” provides the evidence and theory behind the anomaly. The book is a very simple and easy read, without complex, technical jargon or math that can be difficult for nonprofessionals to comprehend. Van Vliet presents his journey from novice investor to academic to practitioner, employing the lessons learned from his own experiences and the published research.
While academics explain the anomaly through such complex mechanisms as limits to arbitrage (which prevent sophisticated investors from correcting mispricings), the authors provide easy-to-understand behavioral explanations (also in the literature).
As an example, they show how relative (instead of absolute) risk can be a career-killer for fund managers. “Relative risk means that you deviate from your peers and your benchmark. Suppose you find a perfect stock with a guaranteed 10% return per year and the market goes up by 30% in one year and down 7% the next. After two years both investments would have grown by an average compounded rate of 10%.”