hongkongen
Low Volatility defies the basic finance principles of risk and reward

Low Volatility defies the basic finance principles of risk and reward

12-11-2021 | Insight

Contrary to popular belief, riskier investments do not necessarily translate into higher returns. Rather paradoxically, we have seen that more volatile stocks tend to yield lower risk-adjusted returns in the long run, while their less volatile peers typically tend to deliver higher risk-adjusted long-term performance.

  • Lusanele Magwa
    Lusanele
    Magwa
    Investment Writer
  • Lejda Bargjo
    Lejda
    Bargjo
    Client Portfolio Manager

Speed read

  • Risk-based theories fail to explain Low Volatility effect
  • Behavioral biases and investor constraints give rise to anomaly
  • Low Volatility premium is persistent over time

The capital asset pricing model (CAPM) dates back to 1964 and has long been the centerpiece used to explain the relationship between risk and return. According to the theory, higher risk should lead to higher returns. Empirical findings, however, contradict this notion. Figure 1 depicts the risk-return profile of ten portfolios sorted on the volatility of historical returns. This clearly shows that the equity market has generally not rewarded investors for taking on more (volatility) risk.

Figure 1 | Long-term risk-return profile of ten volatility-sorted portfolios

Source: Robeco, CRSP. Figure shows average, annualized returns and volatilities of 10 portfolios sorted on past 36-month return volatility. The investment universe covers all common stocks traded on NYSE, AMEX and NASDAQ exchanges with valid market capitalization and return data from 1926 till 2020. Portfolios are equal weighted and portfolio returns are from January 1929 to December 2020.

Low Volatility effect confounds risk-based school of thought

The CAPM assumes a linear relationship between the risk (market sensitivity, i.e., beta) and returns of financial securities. However, numerous studies have illustrated that low beta stocks counterintuitively outperform their high beta peers on a risk-adjusted basis. This was pointed out as far back as the 1970s in a seminal paper that demonstrated that less volatile stock portfolios generated higher returns than riskier counterparts.1

The efficient market hypothesis suggests that low-risk stocks must exhibit other risks that are not captured by their market betas, and this explains their long-term returns. However, attempts to identify these risks have been few and far between. They also pale in comparison to the behavioral finance explanations of the phenomenon.

Low volatility stocks are typically found in defensive sectors and have more predictable cash flows, leading them to exhibit lower valuation uncertainty. Thus, they portray bond-like characteristics, while investors are also likely to use them as replacements for bonds given that they typically pay out dividends. Despite these features, Robeco research concluded that interest rate risk does not account for the long-term added value from low volatility strategies.

Risk-based theories that explain the low volatility effect have largely been disputed within the academic field

In general, risk-based theories that explain the low volatility effect have largely been disputed within the academic field. On the other hand, research from the behavioral school of thought is far more significant on this front.

Investor behavior drives Low Volatility premium

Behavioral biases and constraints offer more convincing reasons for why low volatility stocks have the potential to generate higher risk-adjusted returns than their high volatility counterparts. But in contrast to other factor premiums that are driven by irrational investor behavior, the low volatility anomaly is premised on ‘rational’ investor behavior. Some of the research that explores this premise is outlined below.

Within the investment industry, relative returns often supersede absolute returns as a yardstick for performance or manager aptitude. Low volatility investing can therefore be unpopular due to how markedly different low volatility portfolios can look when compared to benchmarks. This results in higher tracking errors (relative risk) that are not palatable for some investors, especially when short-term underperformance in up markets is a possibility.2 Thus, the desire to keep up with the markets against which portfolios are measured incentivizes investments in high volatility stocks.

The focus on relative performance gives rise to so-called agency issues according to research.3 Investment professionals usually have option-like incentive contracts. They typically seek to maximize the value of these by targeting high portfolio returns, which can cause them to be more attracted to higher-risk stocks.

Another paper states that asset managers are motivated to invest in profit-maximizing, high beta stocks.4 Consequently, they may be willing to overpay for stocks that outperform in up markets, which tend to be highly volatile in nature, and underpay for those that outperform in down markets, which typically have low volatility characteristics.

One academic study also highlights how leverage constraints contribute to the low volatility effect.5 Based on their risk appetite, investors may be able to enhance their returns by leveraging a low volatility portfolio. This may allow them to increase their return potential without taking on additional risk. But due to leverage (or borrowing) constraints, they tend to overweight riskier investments in search of higher returns, therefore lowering their expected returns.

The lottery ticket effect is another documented reason for the low volatility phenomenon.6 Many investors participate in the market to gamble and this steers them towards high-risk stocks due to their upside potential, while their downside risk is limited to the investment amount. In this scenario, the investors are willing to pay a premium for the risk instead of being compensated for it.

Stay informed on our latest insights with monthly mail updates
Stay informed on our latest insights with monthly mail updates
Subscribe

Why hasn’t Low Volatility been arbitraged away?

The low volatility premium has been persistent from as far back as the 1930s

In our view, the low volatility effect is one of the most persistent market anomalies. In 2008, the style became more widely accepted as its watershed moment arrived with the global financial crisis, when it provided downside protection amid the broad-based sell-off. That said, the anomaly has been observed over a long time period and is closely linked to behavioral biases. Indeed, we have observed that the low volatility premium has been persistent from as far back as the 1930s. We believe there are a few reasons why it has not been arbitraged away.

Firstly, due to the importance of relative performance measures within the investment industry, investors typically choose not to deviate significantly from the benchmark, while they simultaneously aim for higher returns than those delivered by it. This dilemma incentivizes them to prefer more volatile stocks compared to their low volatility peers.

Secondly, low volatility ETF investments have increased over time. But even though large amounts of capital are currently invested in low-risk strategies, or those targeting specific defensive sectors, these are balanced against significant assets in high risk or high-risk targeting ETFs.7

Lastly, the lack of leverage constraints and relative performance measures make it attractive for hedge fund managers to exploit the low volatility anomaly. Although they have no leverage constraints and their performance is measured in absolute terms, their option-like incentive structure tilts their preference towards riskier stocks. This helps to keep the low volatility anomaly alive.8

In the next paper of this series, we will discuss the value factor through a behavioral finance lens. In the previous article, we touched on momentum.

1 Haugen, R. A., and Heins, J. A., December 1975, “Risk and the rate of return on financial assets: some old wine in new bottles“, Journal of Financial and Quantitative Analysis.
2 Falkenstein, E., June 2009, “Risk and return in general: theory and evidence”, working paper.
3 Blitz, D., Falkenstein, E., and Van Vliet, P., April 2014, “Explanations for the volatility effect: an overview based on the CAPM assumptions“, Journal of Portfolio Management.
4 Falkenstein, E., March 1996, “Preferences for stock characteristics as revealed by mutual fund portfolio holdings”, Journal of Finance.
5 Frazzini, A., and Pedersen, L. H., January 2014, “Betting against beta”, Journal of Financial Economics.
6 Blitz, D., Van Vliet, P., and Baltussen, G., January 2020, “The volatility effect revisited”, Journal of Portfolio Management.
7 Blitz, D., and Vidojevic, M., December 2020, "The performance of exchange-traded funds", Journal of Alternative Investments; and Blitz, D., August 2017, "Are exchange-traded funds harvesting factor premiums?", Journal of Investment Consulting.
8 Blitz, D., June 2018, “Are hedge funds on the other side of the low volatility trade?”, Journal of Alternative Investments; and Baker, N, L., Haugen, R. A., May 2012, “Low risk stocks outperform within all observable markets of the world“, working paper.

Important information

The contents of this document have not been reviewed by the Securities and Futures Commission ("SFC") in Hong Kong. If you are in any doubt about any of the contents of this document, you should obtain independent professional advice. This document has been distributed by Robeco Hong Kong Limited (‘Robeco’). Robeco is regulated by the SFC in Hong Kong.
This document has been prepared on a confidential basis solely for the recipient and is for information purposes only. Any reproduction or distribution of this documentation, in whole or in part, or the disclosure of its contents, without the prior written consent of Robeco, is prohibited. By accepting this documentation, the recipient agrees to the foregoing
This document is intended to provide the reader with information on Robeco’s specific capabilities, but does not constitute a recommendation to buy or sell certain securities or investment products. Investment decisions should only be based on the relevant prospectus and on thorough financial, fiscal and legal advice. Please refer to the relevant offering documents for details including the risk factors before making any investment decisions.
The contents of this document are based upon sources of information believed to be reliable. This document is not intended for distribution to or use by any person or entity in any jurisdiction or country where such distribution or use would be contrary to local law or regulation.
Investment Involves risks. Historical returns are provided for illustrative purposes only and do not necessarily reflect Robeco’s expectations for the future. The value of your investments may fluctuate. Past performance is no indication of current or future performance.

Logo

Disclaimers

1. General
Please read this information carefully.

This website is prepared and issued by Robeco Hong Kong Limited ("Robeco"), which is a corporation licensed by the Securities and Futures Commission in Hong Kong to engage in Type 1 (dealing in securities); Type 4 (advising in securities) and Type 9 (asset management) regulated activities. The Company does not hold client assets and is subject to the licensing condition that it shall seek the SFC’s prior approval before extending services at retail level. This website has not been reviewed by the Securities and Futures Commission or any regulatory authority in Hong Kong.

2. Important risk disclosures
2. Important risk disclosures Robeco Capital Growth Funds (“the Funds”) are distinguished by their respective specific investment policies or any other specific features. Please read carefully for the risks of the Funds:

  • Some Funds are subject to investment, market, equities, liquidity, counterparty, securities lending and foreign currency risk and risk associated with investments in small and/or mid-capped companies.
  • Some Funds are subject to the risks of investing in emerging markets which include political, economic, legal, regulatory, market, settlement, execution, counterparty and currency risks.
  • Some Funds may invest in China A shares directly through the Qualified Foreign Institutional Investor (“QFII”) scheme and / or RMB Qualified Foreign Institutional Investor (“RQFII”) scheme and / or Stock Connect programmes which may entail additional clearing and settlement, regulatory, operational, counterparty and liquidity risk.
  • For distributing share classes, some Funds may pay out dividend distributions out of capital. Where distributions are paid out of capital, this amounts to a return or withdrawal of part of your original investment or capital gains attributable to that and may result in an immediate decrease in the net asset value of shares.
  • Some Funds’ investments maybe concentrated in one region / one country / one sector / around one theme and therefore the value of the Fund may be more volatile and may be subject to concentration risk.
  • The risk exists that the quantitative techniques used by some Funds may not work and the Funds’ value may be adversely affected.
  • In addition to investment, market, liquidity, counterparty, securities lending, (reverse) repurchase agreements and foreign currency risk, some Funds are subject to risk associated with fixed income investments like credit risk, interest rate risk, convertible bonds risk, ABS risk and the risk of investments in non-investment grade or unrated securities and the risk of investments made in non-investment grade sovereign securities.
  • Some Funds can use derivatives extensively. Robeco Global Consumer Trends Equities can use derivatives for hedging and efficient portfolio management. Derivatives exposure may involve higher counterparty, liquidity and valuation risks. In adverse situations, the Funds may suffer significant losses (even a total loss of the Funds’ assets) from its derivative usage.
  • Robeco European High Yield Bonds is subject to Eurozone risk.
  • Investors may suffer substantial losses of their investments in the Funds. Investor should not invest in the Funds solely based on the information provided in this document and should read the offering documents (including potential risks involved) for details.

3. Local legal and sales restrictions
The Website is to be accessed by “professional investors” only (as defined in the Securities and Futures Ordinance (Cap.571) and/or the Securities and Futures (Professional Investors) Rules (Cap.571D) under the laws of Hong Kong). The Website is not directed at any person in any jurisdiction where (by reason of that person’s nationality, residence or otherwise) the publication or availability of the Website is prohibited. Persons in respect of whom such prohibitions apply or persons other than those specified above must not access this Website. Persons accessing the Website need to be aware that they are responsible themselves for the compliance with all local rules and regulations. By accessing this Website and any of its pages, you acknowledge your agreement with understanding of the following terms of use and legal information. If you do not agree to the terms and conditions below, do not access this Website or any pages thereof.

The information contained in the Website is being provided for information purposes.

Neither information nor any opinion expressed on the Website constitutes a solicitation, an offer or a recommendation to buy, sell or dispose of any investment, to engage in any other transaction or to provide any investment advice or service. The information contained in the Website does not constitute investment advice or a recommendation and was prepared without regard to the specific objectives, financial situation or needs of any particular person who may receive it. An investment in a Robeco product should only be made after reading the related legal documents such as management regulations, prospectuses, most recent annual and semi-annual reports, which can be all be obtained free of charge at www.robeco.com/hk/en and at the Robeco Hong Kong office.

4. Use of the Website
The information is based on certain assumptions, information and conditions applicable at a certain time and may be subject to change at any time without notice. Robeco aims to provide accurate, complete and up-to-date information, obtained from sources of information believed to be reliable. Persons accessing the Website are responsible for their choice and use of the information.

5. Investment performance
No assurance can be given that the investment objective of any investment products will be achieved. No representation or promise as to the performance of any investment products or the return on an investment is made. The value of your investments may fluctuate. The value of the assets of Robeco investment products may also fluctuate as a result of the investment policy and/or the developments on the financial markets. Results obtained in the past are no guarantee for the future. Past performance, projection, or forecast included in this Website should not be taken as an indication or guarantee of future performance, and no representation or warranty, express or implied, is made regarding future performance. Fund performance figures are based on the month-end trading prices and are calculated on a total return basis with dividends reinvested. Return figures versus the benchmark show the investment management result before management and/or performance fees; the fund returns are with dividends reinvested and based on net asset values with prices and exchange rates of the valuation moment of the benchmark.
Investments involve risks. Past performance is not a guide to future performance. Potential investors should read the terms and conditions contained in the relevant offering documents and in particular the investment policies and the risk factors before any investment decision is made. Investors should ensure they fully understand the risks associated with the fund and should also consider their own investment objective and risk tolerance level. Investors are reminded that the value and income (if any) from shares of the fund may be volatile and could change substantially within a short period of time, and investors may not get back the amount they have invested in the fund. If in doubt, please seek independent financial and professional advice.

6. Third party websites
This website includes material from third parties or links to websites maintained by third parties some of which is supplied by companies that are not affiliated to Robeco. Following links to any other off-site pages or websites of third parties shall be at the own risk of the person following such link. Robeco has not reviewed any of the websites linked to or referred to by the Website and does not endorse or accept any responsibility for their content nor the products, services or other items offered through them. Robeco shall have no liability for any losses or damages arising from the use of or reliance on the information contained on websites of third parties, including, without limitation, any loss of profit or any other direct or indirect damage. Third party off-site pages or websites are provided for informational purposes only.

7. Limitation of liability
Robeco as well as (possible) other suppliers of information to the Website accept no responsibility for the contents of the Website or the information or recommendations contained herein, which moreover may be changed without notice.
Robeco assumes no responsibility for ensuring, and makes no warranty, that the functioning of the Website will be uninterrupted or error-free. Robeco assumes no responsibility for the consequences of e-mail messages regarding a Robeco (transaction) service, which either cannot be received or sent, are damaged, received or sent incorrectly, or not received or sent on time.
Neither will Robeco be liable for any loss or damage that may result from access to and use of the Website.

8. Intellectual property
All copyrights, patents, intellectual and other property, and licenses regarding the information on the Website are held and obtained by Robeco. These rights will not be passed to persons accessing this information.

9. Privacy
Robeco guarantees that the data of persons accessing the Website will be treated confidentially in accordance with prevailing data protection regulations. Such data will not be made available to third parties without the approval of the persons accessing the Website, unless Robeco is legally obliged to do so. Please find more details in our Privacy and Cookie Policy.

10. Applicable law
The Website shall be governed by and construed in accordance with the laws of Hong Kong. All disputes arising out of or in connection with the Website shall be submitted to the exclusive jurisdiction of the courts of Hong Kong. 

Please click the “I agree” button if you have read and understood this page and agree to the Disclaimers above and the collection and use of your personal data by Robeco, for the purposes for which such data is collected and used as set out in the Privacy and Cookie Policy, including for the purpose of direct marketing of Robeco products or services. Otherwise, please click “I Disagree” to leave the website.

I Disagree