Investor Attention And The Low Volatility Anomaly

One of the big problems for the first formal asset pricing model developed by financial economists, the Capital Asset Pricing Model (CAPM), was that it predicts a positive relationship between risk and return. However, the historical evidence demonstrates that while the slope of the security market line is generally positive (higher-beta stocks provide higher returns than low-beta stocks), it is flatter than the CAPM suggests.

Importantly, the quintile of stocks with the highest beta meaningfully underperforms the stocks in the lowest-beta quintile in both U.S. and international markets — the highest-beta stocks provide the lowest returns while experiencing much higher volatility (explored in this simulation study). Over the last 50 years, defensive stocks have delivered higher returns than the most aggressive stocks, and defensive strategies, at least those based on volatility, have delivered significant Fama-French three-factor alphas. This runs counter to economic theory, which predicts that higher expected risk is compensated with higher expected return.

The superior performance of stocks with low idiosyncratic volatility was documented in the literature in the 1970s — by Fischer Black (in 1972) among others — even before the size and value premiums were “discovered.” The low-volatility anomaly has been demonstrated to exist in equity markets around the globe. What’s interesting is that this finding is true not only for stocks, but for bonds as well.(1)(2)

Over the past few years, we have had a series of academic papers published that have demonstrated that the returns to low-volatility strategies are well explained by the Fama-French five-factor asset pricing model (which includes the newer factors of profitability and investment, as well as market beta, size and value) and the term factor. The research has also provided us with three main explanations for the low-volatility anomaly:

  1. Many investors are either constrained by 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 the fact that the evidence shows they have delivered poor risk-adjusted returns. Limits to arbitrage, including aversion to shorting and the high cost of shorting such stocks, prevent arbitrageurs from correcting the pricing mistakes.
  2. There are individual investors who have a “taste,” or preference for, lottery-like investments. This leads them to “irrationally” (from an economic perspective) invest in high volatility stocks (which have lottery-like distributions) despite their poor returns — they pay a premium to gamble. In other words, a preference for lotteries may generate a demand for high-volatility stocks that is not warranted by the stocks’ fundamentals.
  3. Mutual fund managers who are judged against benchmarks have an incentive to own higher-beta stocks. In addition, managers’ bonuses are options on the performance of invested stocks, and thus more valuable for high-volatility stocks.
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Full disclosure: My firm, Buckingham Strategic Wealth, recommends Dimensional funds in constructing client portfolios

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