Swedroe: When Risk Offers No Rewards

October 03, 2016

Idiosyncratic (also referred to as nonsystematic) risk is specific to a single asset or to a small group of assets. Idiosyncratic risk has little or no correlation with market risk. Therefore, it can be substantially mitigated or eliminated by sufficiently diversifying a portfolio. Because it can be mitigated, investors aren’t rewarded with higher expected returns for taking idiosyncratic risk.

In fact, one of the major anomalies (or “puzzles”) in finance is that stocks with greater idiosyncratic volatility (IVOL) have produced lower returns. This represents an anomaly because idiosyncratic volatility is viewed as a risk factor—greater volatility should be rewarded with higher, not lower, returns.

Robert Stambaugh, Jianfeng Yu and Yu Yuan, authors of the 2015 study “Arbitrage Asymmetry and the Idiosyncratic Volatility Puzzle,” which appeared in The Journal of Finance, provide an explanation, and the evidence supporting it, for why the anomaly persists.

Arbitrage Deterrents

They begin with the hypothesis that IVOL represents risk that deters arbitrage and its resulting reduction of mispricings. The authors then combine this concept with what they term “arbitrage asymmetry,” which is the greater ability and/or willingness of investors to take a long position as opposed to taking a short position when they perceive mispricing in a security. This asymmetry occurs because there are greater risks and costs involved in shorting, including the potential for unlimited losses.

In addition to the greater risks and costs associated with shorting, for stocks with a low level of institutional ownership, there may not be sufficient shares available to borrow in order for investors to sell them short. Because institutions are the primary lenders of securities, studies have found that when institutional ownership is low, the supply of stocks available to loan tends to be sparse. As a result, short-selling tends to be more expensive.

Furthermore, the charters of many institutions prevent (or severely limit) shorting. And finally, there is the risk that adverse moves in security prices can force capital-constrained investors to reduce their short positions before realizing the profits that would ultimately result from the correction of the mispricing. Importantly, when IVOL is higher, substantial adverse price moves are more likely.

The authors write: “Combining the effects of arbitrage risk and arbitrage asymmetry implies the observed negative relation between IVOL and expected return.” And that is exactly the result they found. Specifically, “the IVOL effect is significantly negative (positive) among the most overpriced (underpriced) stocks and the negative effect among the overpriced stocks is significantly stronger—the negative highest-versus-lowest difference among the most overpriced stocks is 3.7 times the magnitude of the corresponding positive difference among the most underpriced stocks.”


High Macro Risk Boosts Idiosyncratic Risk

Sohnke Bartram, Gregory Brown and Rene Stulz contribute to the body of literature on idiosyncratic volatility through their August 2016 working paper, “Why Does Idiosyncratic Risk Increase with Market Risk?” Their study covered the period 1963 through 2015 and found that “idiosyncratic risk (IR) is high when market risk (MR) is high.”

They also found that when macroeconomic risks or uncertainty are high, IR jumps to 38% as compared to 30% when macroeconomic risks and uncertainty are low.

Bartram, Brown and Stulz also found that liquidity and firm fundamentals help explain the positive correlation of MR and IR, observing that the relationship is weaker for liquid stocks and for growth stocks (providing a risk-based explanation for the value premium).

Additionally, they found an increase in a firm’s market risk is associated with an increase in its idiosyncratic earnings volatility. They noted: “[The relationship] arises partly because shocks to aggregate uncertainty are magnified at the firm level and that the extent to which these shocks are magnified depends on firm characteristics.”

The most important lesson for investors is that, because idiosyncratic risk increases with market risk, the risks of under-diversified portfolios tend to be realized at exactly the worst time, during bear markets. As Bartram, Brown and Stulz state: “Our results suggest that investors not holding fully diversified portfolios need to consider time-variation in idiosyncratic risk in addition to time-variation in market risk.”

When you combine their evidence with the findings that stocks with high IR have poor returns (and even worse risk-adjusted returns), it is easy to understand why diversification has been called the only free lunch in investing (because it reduces risk without reducing expected returns). And given it’s free, you might as well eat as much of it as you can.

I would add this caution: Active managers, by definition, are taking on idiosyncratic risk. The higher their active share, the more IR they assume. For the majority of investors in actively managed funds, this has proven to be the triumph of hope over wisdom and experience.

And as my co-author, Andrew Berkin, and I demonstrate in our book, “The Incredible Shrinking Alpha,” over time, the percentage of active managers who outperform on a risk-adjusted basis has been falling. The result is that, today, only about 2% of active fund managers are generating statistically significant alpha.

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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