Swedroe: Low Vol Advantage Not What You’d Expect

August 08, 2016

The academic research, combined with the experience of the bear market in 2008, has led to low-volatility strategies becoming the darling of investors. For example, as of June 2016, there were five ETFs with at least $3 billion in AUM:

  • PowerShares S&P 500 Low Volatility Portfolio (SPLV): $7.9 billion
  • iShares Edge MSCI Minimum Volatility USA ETF (USMV): $15.1 billion
  • iShares Edge MSCI Minimum Volatility Emerging Markets ETF (EEMV): $3.8 billion
  • iShares Edge MSCI Minimum Volatility Global ETF (ACWV): $3.2 billion
  • iShares Edge MSCI Minimum Volatility EAFE ETF (EFAV): $7.5 billion

Two Schools Of Thought

There are two main explanations offered in the academic literature for the low-volatility advantage:

  1. Many investors are either constrained against the use of leverage or have an aversion to employing it. Such investors who seek higher returns tend to do so by investing in high-beta (or high-volatility) stocks, despite the fact that the evidence shows they have delivered poor risk-adjusted returns. Limits to arbitrage and aversion to shorting, as well as the high costs associated with shorting, prevent arbitrageurs from correcting the pricing mistake.
  2. There are investors who have a “taste,” or preference, for lotterylike investments. This leads them to “irrationally” invest in high-volatility stocks (which have lotterylike distributions) despite their poor returns. In other words, they pay a premium to gamble.

The research has also found that much of the anomaly can be explained by the poor performance of high-volatility stocks, not the outperformance of low-volatility stocks. In fact, there has been very little difference in returns between low- and medium-volatility stocks. Thus, you don’t need to adopt a low-volatility strategy to benefit from this information. You just have to avoid owning the highest-volatility stocks (such as small growth stocks with low profitability and high investment, IPOs and very-low-priced stocks).

David Blitz contributes to the literature with his paper, “The Value of Low Volatility,” which appeared in the Spring 2016 issue of The Journal of Portfolio Management. His study covered the period 1928 through 2014. Using both equal-weighted and value-weighted portfolios, Blitz examined whether low volatility was a unique factor, or whether its performance could be explained by other well-known factors (specifically value).

Defining value by book-to-market ratios, Blitz found that the Fama-French value factor is unable to explain the alpha of low-volatility strategies (with the exception of the period from 1963 through 1984, and even in this case, it was true only for large value stocks).

 

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