Efficient markets theory has been challenged by the finding that relatively simple investment strategies are found to generate statistically significantly higher returns than the market portfolio. Well-known examples are the value, size and momentum strategies, for which return premiums have been documented in US and international stock markets. Market efficiency is also challenged, however, if some simple investment strategy generates a return similar to that of the market, but at a systematically lower level of risk.
An interesting study in this regard is the empirical analysis of the characteristics of minimum variance portfolios in Clarke, de Silva & Thorley (CST, 2006). These authors find that minimum variance portfolios, based on the 1,000 largest US stocks over the 1968-2005 period, achieve a volatility reduction of about 25%, whilst delivering comparable, or even higher, average returns than the market portfolio. We present a simple alternative approach to constructing portfolios with similar risk and return characteristics. Specifically, we create decile portfolios that are based on a straightforward ranking of stocks on their historical return volatility. Contrary to CST, we effectively only use the diagonal of the historical covariance matrix with this approach. We find that portfolios consisting of stocks with the lowest historical volatility are associated with Sharpe ratio improvements which are even larger than those in CST, and statistically significant positive alpha.
A related study in this regard is Ang, Hodrick, Xing & Zhang (AHXZ, 2006), who report that US stocks with high volatility earn abnormally low returns over the 1963-2000 period. These authors focus on a very short term (1 month) volatility measure, while in our study we concentrate on long-term (past 3 years) volatility, which implies a much lower portfolio turnover. Furthermore, we do not only find that high risk stocks are exceptionally unattractive, but also that low risk stocks are particularly attractive.
Ranking stocks on their historical volatility bears a resemblance to ranking stocks on their historical CAPM beta. Theoretically this follows from the fact that the beta of a stock is equal to its correlation with the market portfolio times its historical volatility and divided by the volatility of the market portfolio. Empirically we also observe that portfolios consisting of stocks with a low (high) volatility exhibit a low (high) beta as well. Since the earliest tests of the CAPM researchers have shown that the empirical relation between risk and return is too flat, e.g. Fama & MacBeth (1973). Similarly, others such as Black, Jensen & Scholes (1972) report that low beta stocks contain positive alpha. In their seminal paper, Fama and French (1992) show that beta does not predict return in the 1963-1990 period, especially after controlling for size. In our sample we also find alpha for portfolios ranked on beta, but considerably less than for portfolios ranked on volatility.
Our main contributions to he existing literature are as follows. Firstly, we document a clear volatility effect: low risk stocks exhibit significantly higher risk-adjusted returns than the market portfolio, while high risk stocks significantly underperform on a risk-adjusted basis. Secondly, our findings are not restricted to the US stock market, but apply to both the global and regional stock markets. The alpha spread of the top versus bottom decile portfolio amounts to 12% per annum for our universe of global large-cap stocks over the 1986-2006 period. Thirdly, we compare the volatility effect with the classic size, value and momentum strategies and control for these effects. In order to disentangle the volatility effect from those other effects we use global and local Fama and French regressions and apply a double sorting methodology. We find that the volatility effect is in fact a separate effect, and of comparable magnitude. Fourthly, we provide possible explanations for the success of the strategy which include leverage restrictions, inefficient industry practice or behavioral biases among private investors, which all flatten the risk-return relation. Finally, we argue that benefiting from the low volatility effect in reality is not easy, as long as institutional investors do not include low risk stocks as a separate asset class in their strategic asset allocation process.
The remainder of this paper is organized as follows. In the following section we first describe our data and methodology. Our primary focus is on a universe of global large-cap stocks. Subsequently, we present results for the US, European and Japanese markets in isolation. In the next section we control for other cross-sectional effects, again tested on global and regional markets separately. This is followed by a discussion of possible explanations for the superior Sharpe ratios of low risk portfolios. We end with our conclusions and implications for investors.
This report is not available for users from countries where the offering of foreign financial services is not permitted, such as US Persons.
Your details are not shared with third parties. This information is exclusively intended for professional investors. All requests are checked.
Please read this important information before proceeding further. It contains legal and regulatory notices relevant to the information contained on this website.
The information contained in the Website is NOT FOR RETAIL CLIENTS - The information contained in the Website is solely intended for professional investors, defined as investors which (1) qualify as professional clients within the meaning of the Markets in Financial Instruments Directive (MiFID), (2) have requested to be treated as professional clients within the meaning of the MiFID or (3) are authorized to receive such information under any other applicable laws. The value of the investments may fluctuate. Past performance is no guarantee of future results. Investors may not get back the amount originally invested. Neither Robeco Institutional Asset Management B.V. nor any of its affiliates guarantees the performance or the future returns of any investments. If the currency in which the past performance is displayed differs from the currency of the country in which you reside, then you should be aware that due to exchange rate fluctuations the performance shown may increase or decrease if converted into your local currency.
In the UK, Robeco Institutional Asset Management B.V. (“ROBECO”) only markets its funds to institutional clients and professional investors. Private investors seeking information about ROBECO should visit our corporate website www.robeco.com or contact their financial adviser. ROBECO will not be liable for any damages or losses suffered by private investors accessing these areas.
In the UK, ROBECO Funds has marketing approval for the funds listed on this website, all of which are UCITS funds. ROBECO is authorized by the AFM and subject to limited regulation by the Financial Conduct Authority. Details about the extent of our regulation by the Financial Conduct Authority are available from us on request.
Many of the protections provided by the United Kingdom regulatory framework may not apply to investments in ROBECO Funds, including access to the Financial Services Compensation Scheme and the Financial Ombudsman Service. No representation, warranty or undertaking is given as to the accuracy or completeness of the information on this website.
If you are not an institutional client or professional investor you should therefore not proceed. By proceeding please note that we will be treating you as a professional client for regulatory purposes and you agree to be bound by our terms and conditions.