Low-Volatility Investing: Collected Robeco Articles
David Blitz, PhD, Pim van Vliet, PhD
We are happy to be able to present to you this collection of 24 research articles dedicated to low-volatility investing. This is a highly relevant topic for both investment professionals and academics, and its simple but powerful message of ‘lower risk without a lower return’ is rapidly spreading throughout the global investment community. As this empirical fact is also highly counterintuitive, it deserves further study; especially as it offers great future potential to those already invested in low-volatility strategies and to those who are considering it.
The paradox, or market anomaly, of low volatility raises many questions. This explains the number of articles on this topic that have appeared in various academic journals or have been published as proprietary client research papers. This totally revised second edition replaces the first book of collected articles published in April 2012. The introduction is divided into three parts covering the past, the present and the future, and aims to give a general introduction and a broad reflection on low-volatility investing, looking at developments from both an academic and an industry perspective.
The rise of passive investing
In the 1970s there was increasing support for the notion that stock markets were efficient. The Nobel Prize-winning Capital Asset Pricing Model (CAPM) was developed and some early tests were carried out. If the CAPM holds true, one should buy and hold the market-weighted portfolio. The theory seemed to work reasonably well, although some issues remained, and the logical consequence was the rise of passive investing. Passive market-index investing therefore became a theoretically powerful concept, supported by the fact that on average, active funds underperform the market after costs.
The rise of factor investing
Passive investing continued to win global market share. However, one of the issues was the risk-return relationship. While theory predicted that more risky stocks would on average earn a higher return, the reality was that when tested, the relationship between risk and return was rather flat. The late Professor Haugen was one of the few people who highlighted this lack of a positive risk-return relationship, but he was mostly ignored. Most research in the 1980s and 1990s was devoted to stock market anomalies such as value, size and momentum. These factors give a clear premium, whereas low volatility gives a risk-adjusted premium. The most cited research work by Fama and French, written in the early 1990s, basically ignores the low-beta effect and focuses on size and value instead. Therefore, it wasn’t a surprise that these factors were in the spotlights of academia and investors. This research led to the rise of factor investing, where some innovative investors started directly allocating to academic factors such as size and value. This development was fueled by asset managers and index providers offering specific small cap and value strategies.
The rise of low-volatility investing
Only in the 2000s did academic articles start to appear which explicitly looked at the lowrisk effect from different angles. These studies demonstrated that low-risk stocks have high risk-adjusted returns and high-risk stocks have low-risk adjusted returns. Overall the findings were very robust with regards to methodology (sorting or optimizing), risk measure (beta, volatility, idiosyncratic volatility), sample period, market (US or international), return frequency, factor exposure (controlled for value, size and momentum) and many other tests. Fueled by these research insights, low-volatility strategies and indices started to emerge: the rise of low-volatility investing.
The global financial crisis: a change in our collective mindset
In the 2000s, several pioneering asset managers began to run low-volatility strategies, mostly in Europe but also some in the US. The first investors started to allocate directly to these strategies. However, of the range of factors available, low volatility was the most difficult one to grasp, because it does not offer a clear and consistent outperformance. The global financial crisis was a blessing in disguise for low volatility because in 2008, this was the only factor offering significant ‘outperformance’, which automatically drew attention to it. But most potential investors were constrained, specifically by benchmarks and outperformance targets.
The rise of low-volatility indices really helped to overcome these hurdles. MSCI was the firstly to provide a minimum volatility index, in early 2008. Investors were then able to firstly assess their strategic choice for low volatility by monitoring the index, and secondly also assess the quality of their active or passive manager against this index – just as they could with other investments. 2011 was another defining year, when low-volatility investors enjoyed good relative and absolute performance. This was the year in which low-volatility investing really took off. However in the period that followed (2012-2014), which was characterized by rising equity markets with historically low volatility, on average low-volatility stocks underperformed. The fact that so many investors continued to allocate more, despite years of weak relative performance, indicated that something had changed in our collective mindset. This may be similar to the generation who lived through the 1930s – those who experienced 2008 and the subsequent recession have become more risk-averse than previous generations.
Explaining the anomaly
Although research devoted to low-volatility investing has increased, it is still dwarfed by the amount of attention given to other academically established factors such as size, value and momentum. This could be because the low-risk factor does not offer a clear premium, but a higher risk-adjusted return. Since many academics still believe in a positive risk-return relationship, it makes more sense to explain a factor premium using risk (e.g. search for alternative risk-based explanations for the value premium), than to explain the absence of a premium altogether. This makes it rather an inconvenient truth because much financial theory becomes irrelevant.
Many researchers seem to be constrained by their assumptions, as investors are constrained by their benchmark. Interestingly, the research papers that have been written on the topic are mostly written by academics with practical exposure or practitioners with links to universities, publishing their work in applied journals such as the Journal of Portfolio Management and Financial Analyst Journal. Currently, relative utility models (which include relative performance) and agency-based models (which include incentives and constraints) are helping us to better understand financial markets in general and the low-volatility anomaly in particular.
Nowadays, low volatility is an accepted new factor and appears as a core holding in many investment portfolios. Allocations are highest among US private investors and European institutional investors with increasing allocations from institutional investors in Asia and Australia. We estimate the total assets to be around USD 200 billion spread over ETFs, passive portfolios and active strategies. This amounts to only 0.5% of total equity market value. The question is what percentage will be required to counterbalance all those forces which cause the volatility effect. It should be noted that passive market-weight investors sustain the effect, because they do not correct the prices of stocks.
Critical views manage expectations
Currently, all large index providers offer low-volatility indices and most quantitative asset managers also offer low-volatility strategies. The names might vary from minimum volatility, conservative to managed volatility, minimum variance and defensive, but they all exploit the low-volatility effect in one way or another. In response to the popularity of these new products, critical views have emerged – frequently-voiced worries relate to the valuation risk and interest-rate sensitivity of low-volatility stocks. These views are very useful in helping investors to better understand this factor and may help improve low-volatility strategies. In an active strategy, interest-rate risk can be partially mitigated and the valuation risk even reversed. Less well known is that low-volatility stocks in the shorter term do not always offer full downside protection.
This debate and critical views offer additional insights which will help to manage expectations. A good example of managed expectations is that most investors know that low-volatility stocks tend to lag during sustained bull markets. Patience and persistence are needed to successfully exploit an investment anomaly. Building realistic expectations strengthens long-term commitment among investors. This will help them to fully reap the benefits of this fine factor in the future.
Many questions still remain unanswered
The increasing popularity of low-volatility investing means that more research papers will be written on this topic. Hopefully some of the still open questions will be answered: what is the most important explanation for the low-volatility effect? In which circumstances do low-volatility stocks fail to offer downside protection? As not all low-volatility stocks are equal, which subset offers the best protection? How exactly do other factors such as value and momentum interact with low volatility? Should an active low-volatility strategy avoid negative value and momentum exposure, or go one step further and aim for positive exposure? What causes value stocks to wander from low volatility to high volatility over time? How much money is needed to counterbalance the forces driving the mispricing of low-volatility stocks? Will USD 1 trillion be enough, or should it be more? Does the continuing trend towards passive market cap investing impact this figure? Will the capacity of low-volatility indices be relatively low, because their rebalancing process is fully transparent, and predatory traders can easily benefit around rebalancing dates?
The answers to these questions will shape the future landscape of low-volatility investing. We hope that the existing research questions will be answered and many new useful questions will be raised in the years to come. This will lead to a better understanding of why this segment of the market is underpriced and how investors can profit more effectively.
Aging population will fuel demand
The low-volatility investment landscape will certainly change over the coming years. More products will be launched, increasing the choice for investors. Investment consultants will play a more important role in helping clients to choose a good low-volatility solution. This external guidance will be especially important if the number of governance rules further increases. Capital preservation is always important, but it is especially important for aging populations. This trend will fuel additional demand for low-volatility strategies. In the US, growth will probably come from institutional investors, and in Europe, from wholesale investors, while Asia-Pacific will probably see the largest increases.
Shake-out and healthy growth
A shake-out at some point in the future is inevitable if low volatility enters a sustained period of weak returns. One can only speculate as to how many investors would have sufficient staying power in such an environment and when they would begin withdrawing money. The quality of the different low-volatility approaches will become clearer in the future. Also the way in which expectations are managed by low-volatility providers will be a key factor in determining the staying power of low-volatility investors in challenging environments. Still, we are in the midst of a silent success story. Low-volatility investing is slowly gaining more traction and investors worldwide are gradually increasing their allocations. This is somewhat similar to the gradual rise of passive investing, which took decades to achieve its current market size.
The slow and thoughtful adoption is good for all involved in low-volatility investing. Some skepticism is also healthy when it comes to managing expectations. Over recent years we have also written several critical articles on low-volatility investing. You will find these in the final section of this book. Each article can be read independently. We have also included summaries of each part in order to help readers with time constraints. We are pleased to participate in this important debate and hope you find the results of our research insightful.