Swedroe: A Factor With Caveats

September 14, 2018


The low-beta anomaly was documented almost 50 years ago. It has been persistent and pervasive around the globe and across asset classes. However, research demonstrates not only that returns to the anomaly are well-explained by exposure to what are now considered other common factors (mainly value, quality and term), but that the premium is dependent on whether low volatility is in the value or growth regime, whether past recent returns were high or low, and the performance of the size premium.

The returns to the premium have only justified investing when low-beta stocks are in the value regime, after periods of strong market and small-cap stock performance, and when they exclude high-beta stocks that have low short interest. This may be why live funds have been generating large negative alphas once we account for common factor exposures.

In addition, taxable investors should consider the negative tax impact of dividends, as low-beta/low-volatility strategies tend to pay higher dividends. Finally, today’s investors should be concerned about the curse of popularity and the resulting rise in valuations, which historically have predicted negative returns to the low-volatility anomaly.

It’s also important to note that long-only funds that don’t focus on this anomaly can benefit from screening out lottery stocks that drive the poor performance of securities in the highest quintile of beta. For example, firms such as Bridgeway Capital Management and Dimensional Fund Advisors have long screened out such stocks. They also have suspended purchases when stocks are “on special” (that is, they have high security lending fees). Thus, they are able to benefit from the anomaly without shorting. (Full disclosure: My firm, Buckingham Strategic Wealth, recommends Bridgeway and Dimensional funds in constructing client portfolios.)

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

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