As far back as the early 1970s, research has shown that the lowest volatility stocks have provided better returns than the highest volatility stocks. These findings run counter to economic theory, resulting in the low-volatility anomaly. The academic research, combined with the 2008 bear market, has led to low-volatility strategies becoming a darling of investors. For example, as of July 3, 2014, five low-volatility ETFs had reached at least $1 billion in assets under management:
- PowerShares S&P 500 Low Volatility Portfolio (SPLV): $4.1 billion
- iShares MSCI USA Minimum Volatility Index Fund (USMV): $2.6 billion
- iShares MSCI Emerging Markets Minimum Volatility Index Fund (EEMV): $2.0 billion
- iShares MSCI All Country World Minimum Volatility Index Fund (ACWV): $1.2 billion
- iShares MSCI EAFE Minimum Volatility Index Fund (EFAV): $1.2 billion
There are two main explanations for the low-volatility anomaly:
- Many investors are either constrained against the use of leverage or have an aversion to its use. Such investors who seek higher returns do so by investing in high beta, or high-volatility, stocks - despite evidence showing they have delivered poor risk-adjusted returns. Limits to arbitrage and an aversion to shorting, as well as the high cost of shorting such stocks, prevent arbitrageurs from correcting the pricing mistake.
- There are investors who have a preference, or a "taste," for lottery-like investments. This leads such investors to "irrationally" invest in high-volatility stocks despite their poor returns. They pay a premium to gamble.
The research has also found that much, if not most, 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 adapt a low-volatility strategy to benefit from the information. You just have to avoid the highest volatility stocks, such as extreme small-growth stocks, IPOs and very low priced stocks.
Xi Li, Rodney Sullivan and Luis Garcia-Feijóo added to the research on the low-volatility anomaly with their recent study, "The Limits to Arbitrage and the Low-Volatility Anomaly," which appeared in the January-February 2014 issue of the Financial Analysts Journal. The authors found that excess returns associated with forming long low-volatility and short high-volatility portfolios are generally present only in the first month after formation. After that, excess returns are largely subsumed by the high transaction costs associated with stocks that have low liquidity, such as low-priced or high-volatility stocks. The authors also found that anomalous returns within value-weighted portfolios are largely eliminated when omitting low-priced (less than $5) stocks, and are not at all present within equal-weighted portfolios. In fact, the average price of stocks in the highest volatility quintile was just over $7, indicating that many, if not most, would be considered "penny stocks." And finally, the authors found that the low-risk effect has been noticeably weaker since 1990. New regulations were passed in that year aimed at reducing fraud associated with trading penny stocks. I'll add here that many of the high-beta stocks simply disappeared after the dot.com crash, and the number of stocks on public U.S. exchanges has shrunk dramatically since then. The authors conclude: "Our findings cast some doubt on the practical profitability of a low risk trading strategy."
A new study by Bradford Jordan and Timothy Riley, "The Long and Short of the Vol Anomaly," makes a further contribution to the literature on the low-volatility anomaly. The study, which covers the period from July 1991 to December 2012, was published in June. The authors were motivated by prior research which has shown that, separately, high-volatility stocks and stocks with high short interest both exhibit poor risk-adjusted future performance. However, no one had studied the two together. The conventional wisdom is that high short interest is a bullish signal because it predicts future buying from short covering, but the reality is that stocks with high short interest perform poorly on average. The study found that while, on average, stocks with high prior-period volatility underperformed those with low prior-period volatility, that comparison is misleading because among high-volatility stocks, those with low short interest actually experience extraordinary positive returns. On the other hand, those with high short interest experience equally extraordinary negative returns. The bottom line is that high volatility on its own isn't an indicator of poor future returns. In fact, the study found that for the period from July 1991 to December 2012, stocks with high volatility and low short interest would have outperformed the CRSP value-weighted index by 9 percent a year. The study also found that a portfolio long on high-volatility and high short interest stocks had a four-factor alpha of -9 percent a year.
Another important finding was that high-volatility and low short interest stocks outperform the market in turbulent times, such as the dot.com crash and the 2007-2009 financial crisis. During the dot.com bubble, an equally weighted high-volatility and low short interest portfolio had an annualized compound return 3.5 percent greater than that of the CRSP value-weighted index. During the financial crisis, that same gap was 13.3 percent.
It's important to note that the study's findings have implications for long-only strategies because buying high-volatility stocks with low short interest avoids the limits of arbitrage and high costs of shorting strategies. While the study's authors did find that high-volatility stocks with low short interest are less liquid than the average stock - so execution costs could prevent realizing returns - they found no significant difference in performance between those stocks in the group with high or low liquidity. In addition, low short interest stocks are typically larger stocks with higher trading volumes. High-volatility and high short interest stocks have an average size of $559 million, compared with an average size of about $2 billion for high volatility and low short interest stocks. Thus, long only investors can use screens to eliminate stocks with low liquidity, or they can use patient-trading strategies to minimize turnover costs.
The authors reach this conclusion: "Based on the evidence in this study, the current 'low vol' investing fad has little or no real foundation."
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