Swedroe: A Factor With Caveats

September 14, 2018

As director of research for Buckingham Strategic Wealth and The BAM Alliance, I’ve been getting lots of questions lately regarding the advisability of investing in the low-beta/low-volatility anomaly. These concerns have been heightened by the financial media’s focus both on the fact that we are now in the longest bull market in history and that current valuations are at historically high levels.

With that in mind, I thought I would review the literature on the low-beta/low-volatility anomaly and the related issue of the “curse of popularity” (that is, what happens when a trade gets “crowded”).

One of the big problems for the first formal asset pricing model developed by financial economists, the CAPM, was that it predicts a positive relationship between risk and return. But empirical studies have found the actual relationship to be basically flat, or even negative. “Defensive” stocks have produced high returns on average in comparison to more “aggressive” 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 has been shown to exist in equity markets around the world. Interestingly, this finding is true not only for stocks, but for bonds. In other words, it has been pervasive.

My book, co-authored with Andrew Berkin, “Your Complete Guide to Factor-Based Investing,” included an in-depth discussion of the explanations for the existence and persistence of the anomaly. Among the explanations are:

  • Many investors are constrained against the use of leverage (by their charters) or have an aversion to its use. The same is true of short-selling.
  • Borrowing costs for some hard-to-borrow stocks can be quite high. Such limits can prevent arbitrageurs from correcting the pricing mistake.
  • While an assumption of the CAPM is that markets have no frictions, meaning there are neither transaction costs nor taxes, in the real world, there are costs. The evidence shows that the most mispriced stocks are the ones with the highest costs of shorting.
  • Regulatory constraints, which often don’t differentiate between the risks of low-beta and high-beta stocks, lead some investors to prefer high-beta stocks.
  • There is a preference for “lottery tickets”—high-beta stocks with a low average return but a small chance of a large return.

The academic research, combined with the 2008 bear market, led low-volatility strategies to become the darling of investors. But is it worthy of such admiration as an independent factor? Let’s examine the research.

Other Factor Exposures Explain Returns To Low Beta

Both Robert Novy-Marx’s 2016 study, “Understanding Defensive Equity,” and Eugene Fama and Kenneth French’s 2015 study, “Dissecting Anomalies with a Five-Factor Model,” argued that the low-volatility and low-beta anomalies are well-explained by asset pricing models that include the newer factors of profitability and investment (in addition to market beta, size and value).

Stefano Ciliberti, Yves Lemperiere, Alexios Beveratos, Guillaume Simon, Laurent Laloux, Marc Potters and Jean-Philippe Bouchaud, authors of the 2017 paper “Deconstructing the Low-Vol Anomaly,” studied the factor on a global basis and found that once the common factors of value and profitability are controlled for, the performance of low volatility/low beta becomes insignificant.

Esben Hedegaard, author of the June 2018 study, “Time-Varying Leverage Demand and Predictability of Betting-Against-Beta,” found that high (low) past returns on the market forecast high (low) future returns on the BAB factor—realized BAB returns are higher (lower) following high (low) past market returns. Because expected returns move opposite to prices, high (low) market returns lead to contemporaneously low (high) returns on the BAB factor.

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