An article I wrote in September discussed the findings of the study, “Benchmarks as Limits to Arbitrage: Understanding the Low-Volatility Anomaly,” in which the authors proposed a new explanation for why anomalies (such as the low-beta/low-volatility anomaly) persist.
They hypothesized that the typical institutional investor’s mandate to maximize the ratio of excess returns relative to a fixed benchmark without resorting to leverage can affect the relationship between risk and expected return.
Many institutional investors who are in a position to offset an irrational demand for risky assets also have fixed benchmark mandates that are typically capitalization-weighted. Thus, straying from the benchmarks to exploit anomalies creates career risk.
The study’s authors concluded: “The combination of irrational investor demand for high volatility and delegated investment management with fixed benchmarks and no leverage flattens the relationship between risk and return. Yet, sophisticated investors are to a large extent sidelined by their mandates of maximizing active return subject to benchmark tracking error.” Thus, the anomaly persists.
Andrea Buffa, Dimitri Vayanos and Paul Woolley—authors of the September 2014 paper, “Asset Management Contracts and Equilibrium Prices”—took a different approach to the question of why these anomalies persist.
However, they also examined whether or not fund manager contracts—in which performance relative to a benchmark determines a manager’s compensation and the funds they get to manage—lead managers to become less willing to deviate from that benchmark.
And if that is the case, the authors ask, do the price distortions fund managers are hired to exploit then become more severe? The following are some of their key conclusions:
“While distortions are exacerbated in both directions, i.e., undervalued assets become cheaper and overvalued assets become more expensive, the positive distortions dominate, biasing the aggregate market upwards and its expected return downwards. Indeed, overvalued assets account for an increasingly large fraction of market movements relative to undervalued assets. Therefore, trading against overvaluation, by underweighting the overvalued assets, exposes managers to greater risk of under-performing their benchmark than trading against undervaluation.”
“In addition to exacerbating price distortions, agency frictions can generate a negative relationship between risk and expected return in the cross-section. Such a negative relationship has been documented empirically, with risk being measured by return volatility or CAPM beta, and contradicts basic predictions of standard theories.”
There are, as we know, other explanations that may contribute to the persistence of anomalies. Those explanations include limits to arbitrage, which prevent rational investors from exploiting the anomaly. For example:
- Many institutional investors (such as pension plans, endowments and mutual funds) are prohibited by their charters from taking short positions.
- Shorting can be expensive. You have to borrow a stock to go short, and many stocks are costly to borrow because there are low supplies of available equities from institutional investors.
- Investors are unwilling to accept the risks of shorting because of the potential for unlimited losses. Even traders who believe that a stock’s price is too high know they can be correct, and the price may in fact eventually fall, but that they still face the risk that the price will go up before it goes down. Such a price move, requiring additional capital, can force the traders to liquidate at a loss.
Low-Vol Anomaly Explained?
The bottom line is that the research on management incentives does seem to provide at least one explanation for the existence of the low-volatility anomaly, as well as why it can persist even well after the investing public is made aware of its presence.
But what may be the most interesting development surrounding this issue is the introduction of passively managed funds that seek to directly exploit anomalies, such as the low-volatility phenomenon.
Other funds attempt to indirectly exploit the anomaly by incorporating negative screens so that certain stocks (such as extreme small-growth stocks with low profitability) will not be included on the eligible buy lists.
Finally, perhaps institutional investors would be better served by not using capitalization-weighted benchmarks to gauge the performance of active managers. An alternative would be to measure their performance against a well-known factor model, such as the Fama-French Three-Factor (market, size and value) or Four-Factor (market, size, value and momentum) models.
They could even use one of the newer models that incorporate the factors of profitability (or quality) and investment. The manager could then be judged by whether or not the fund is achieving the desired factor exposures and also whether the manager is adding or subtracting alpha.
Larry Swedroe is the director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.