High returns with low risk: A remarkable stock market paradox
The Low volatility premium is maybe essentially the most compelling anomaly in financial markets: Less dangerous securities outperform their riskier counterparts long-term.
Empirical tests of the Capital Asset Pricing Model (CAPM) first documented this counterintuitive phenomenon greater than half a century ago. It arose not within the seek for alpha, but as an unwelcome reality, an unintended consequence of theory testing and remains to be poorly understood til today.
This makes the defensive low volatility factor unique and different from other aspects.
Because the factor is low volatility contradicts a risk-based explanationScientists who consider in efficient markets have difficulty accepting this. In fact, Eugene Fama and Kenneth French ignored low volatility Three-factor And Five-factor models.
In contrast, practitioners often struggle to capitalize on this factor attributable to its high risk relative to its benchmarks, limited leverage and potential profession risks.
Such complexities and hurdles make low volatility a special animal within the expanding “factor zoo”.
Nevertheless, the low volatility factor is each resilient and robust.
By applying the principle here that the best explanation is normally essentially the most accurate – Occam’s Razor – we argue for low volatility. The chart below shows how low volatility interacts with other aspects. Even after seven cuts or slices, the factor still works. If it retains its alpha after so many slices, its simplicity have to be the important thing to its importance.
The place to begin: CAPM
We measure using US market data from July 1940 to December 2023 the volatility factor Similar to a Fama and French style factor by taking a protracted position on low volatility stocks and a brief position on their high volatility counterparts. During this era, the low volatility premium (VOL) is 6.4% with a beta that could be very near zero by design. The CAPM alpha is 6.3% per 12 months with a T-stat of 5.3, well above the critical values Campbell Harvey really helpful minimizing the danger of finding “false factors.”
Low volatility premium (VOL) controlled for other aspects, July 1940 to December 2023
Sources: The Kenneth R. French Data Library And Paradoxical investing
The first section, 2FM (Interest Rates): Two aspects, stocks and bonds
When the CAPM was introduced, Richard Roll criticized that bonds and other assets must be included out there portfolio. Since low volatility stocks are much like bond-like stocks, this higher rate of interest sensitivity could possibly be an evidence. Nevertheless, a two-factor regression that features each stocks and bonds only reduces VOL’s alpha by 0.3%.
Second section, FF 3FM: Fama-French three-factor model
One explanation for the low volatility factor is that value is commonly defensive. While the connection varies over time, on average volatility has a positive impact on value and a negative impact on size. The classic three-factor Fama-French regression, which incorporates each the worth and size aspects, reduces the alpha of VOL by 1.1%.
Third section, 4FM (Inv): three-factor model plus investment
Fama and French expanded their three-factor model in 2015 to incorporate two additional aspects – investment and profitability. We find that the investment factor accounts for roughly 0.5% of VOL’s alpha. This makes intuitive sense because conservative firms with low investments are likely to have lower volatility.
Fourth section, 4FM (Prof): Three-factor model plus profitability
Of these two recent aspects, profitability has a much stronger connection to volatility, accounting for 1.2% of VOL’s alpha. We find that unprofitable firms are likely to be very volatile, even when their profitable competitors don’t all the time show the other. Therefore, the short section is basically chargeable for this result.
Fifth section, FF 5FM: Fama-French five-factor model
Combined, these five aspects cause VOL’s alpha to diminish by 0.9%. This suggests that investment and profitability are different dimensions of quality rating that interact with value and size.
Sixth section, 6FM (Mom): Five-factor model plus momentum
The most dynamic factor momentum, generates high gross returns, but requires significant turnover, which reduces net returns. For this reason, Fama and French didn’t include it of their five-factor model. When we add momentum, the VOL premium doesn’t rise or fall.
Seventh section, 7FM: The Kitchen Sink
In our final, all-encompassing “kitchen sink” regression, the alpha of VOL drops by 0.2% and remains to be at a statistically significant 2.1%.
All of this shows the general robustness of low volatility. The factor’s outperformance survives criticism from all angles. By applying Occam’s Razor to the factor zoo and reducing low volatility in all directions, the strategy still stands out as a very powerful factor. If it takes 5 – 6 aspects to clarify it, perhaps low volatility is not so bad in spite of everything.
To go one step further by integrating value, quality and dynamism into one “Conservative formula” We are developing an improved low volatility strategy that outperforms VOL together with all other aspects. The image below shows how the Conservative Minus Speculative (CMS) portfolio performs after each of our previous cuts. The alpha starts at 13.3% and only drops to eight.2% in spite of everything seven slices.
Enhanced Volatility Premium (CMS), controlled for other aspects, July 1940 to December 2023
Sources: The Kenneth R. French Data Library And Paradoxical investing
Given the low demand for defensive assets through the recent technology-driven market rally, the case for low-volatility investing could also be stronger than ever. In a market that usually overlooks this, and in a world where the apparent is commonly crowded and overvalued, the low volatility anomaly is a testament to the facility of contrarian pondering.
Sometimes the trail less traveled offers the higher journey. Looking forward, the query stays: Will the market eventually meet up with this hidden gem, or will low volatility proceed to be the market’s best-kept secret?
Don’t miss out on more information from Pim van Vliet, PhD with Jan de Koning.
Photo credit: ©Getty Images / Jordan Lye
