Updated: Nov 17
Periods of Under- and Outperformance Come and Go
Minimum-vol strategies are lagging the market this year, despite a drop in interest rates and a wall of worries. As illustrated by the graph below, the USMV 1-year rolling price return has seen periods of both out- and underperformance (the dates on the X-axis represent the purchasing dates and reflect the subsequent 1-year performance). For example, in 2016 when Donald Trump was elected, risky assets substantially outperformed their low-risk counterparts as interest rates increased in a rosy economic environment. On the other hand, the low-vol approach clearly demonstrated its true strength in 2018 and it was even capable of capturing most of the SPY's upside during 2019. This year, however, high-beta tech stocks surged and most low-volatility stocks (insurance companies, over-levered REITs) along with cyclicals gapped down.
Due to the recent vaccine news, one might question the relevance of preferring low-risk equities with excellent momentum over high-beta stocks. Shouldn't we just rotate into cyclical, beaten down stocks?
(Source: Option Generator Research)
Robeco's Take on Low-Vol Investing
Robeco's groundbreaking approach to investing in low-volatility equities with decent momentum and quality features (also known as "Conservative Equities") stresses the importance of taking a long-term view on the low-vol anomaly. There's no strategy that will always outperform in every market environment, though, it's by understanding the probabilities and long-term strategic advantage that we feel confident in the strategy we're executing.
As always, an average doesn't tell the whole story. It's better to look at the distribution of the results. Illustrated by the figure below, there's a 20% probability that low-volatility stocks are going to underperform the market during down-months.
This is probably the most important message: expect low-volatility to drastically underperform during up markets: about 70% of the time you'll be lagging the benchmark. By adding momentum and sustainable dividend growth to the equation (low-vol enhanced), the odds of underperforming during up markets after 3 years is expected to land at 30%.
The fact that low-volatility stocks are oftentimes being perceived as bond-proxy investments (vast cash flows, visibility...) means that there tends to be an inverse relationship with the benchmark's performance.
However, in the end, it's all about this graph:
Robeco's pratical implementation and quantitative research on low-volatility investing are undoubtedly revolutionary. It doesn't pay off to buy the riskiest stocks in the universe.
Why isn't everybody doing this? First and foremost, if you're bullish on the stock market you'd better buy higher-beta stocks as the probability of outperformance for low-vol strategies is less than 50%. On the contrary, if you're worried about a steeper market correction, you're not going to buy equities at all, you'd better stick to cash in that case. Stated differently, there's no incentive for active fund managers and investors in general to buy low-vol stocks. Timing these two inflection points (a new rally or the beginning of a bear market) leads to substantial underperformance in the long run.
While low-vol stocks with good momentum and high-quality features (solid moat, dividend aristocrat status et cetera) enjoy smaller drawdowns, bringing in option strategies will enhance the risk-adjusted returns even further. Nonetheless, it's all about patience and letting the strategy work out in your favor.
Investors Are Overconfident & Focus on Media-Driven Stocks
The literature provides us with many possible explanations for the low volatility anomaly, including this behavioral one—investor overconfidence. Investors (including active fund managers) are overconfident. The result of overconfidence is that we have a violation of the assumptions used by the CAPM, which is predicated on rational information processing. The impact on the volatility effect is that, if an active manager is skilled, it makes sense to be particularly active in the high-volatility segment of the market because that segment offers the largest rewards for skill. However, this results in excess demand for high-volatility stocks. While there are many possible explanations, what does seem clear is that many of them come from either constraints and/or agency issues driving managers toward higher-volatility stocks. Given that there does not seem to be anything on the horizon that would have a dampening impact on these issues, it appears likely the anomaly can persist. In addition, human nature does not easily change. Thus, there does not seem to be any reason to believe that investors will abandon their preference for “lottery ticket” investments. And limits to arbitrage, as well as the fear and costs of margin, make it difficult for arbitrageurs to correct mispricings.
The bottom line is that low volatility has predicted low volatility and likely will continue to do so. And while it seems likely that the constraints and limits to arbitrage will allow the high volatility stocks to continue to underperform, whether the high returns to low volatility strategies will continue to present an anomaly is another question. One reason is that popularity leads to cash flows which can cause premiums to either shrink or disappear.
The possibility of a low-volatility effect has been known since the work of the near-Nobel Prize-winning economist Fischer Black as far back as 19721. Black (1972) pointed out that if investors want to take more risk than the market, they can leverage up the market portfolio. But if leverage is unavailable or costly, they may choose to buy high-risk (high-volatility) stocks instead, leaving low-volatility stocks undersubscribed and underpriced. Black expressed this concept by saying that the CAPM line should appear flatter under conditions of restricted leverage than it would be otherwise.
Traditional finance says that if conditions in the market make it possible for arbitrageurs to earn a large riskless profit (larger than the cost of executing the arbitrage), the condition will disappear. In the case of Black’s solid line, arbitrageurs would short high-beta stocks and buy low-beta stocks in such proportions that the overall beta of the arbitrage portfolio would be zero, but with a large positive expected return. Arbitrageurs would thus push the solid line back toward the CAPM dashed line and the superior risk-adjusted return of low-beta stocks would disappear.
In practice it seems that few people are engaging in this arbitrage. First, it is far from riskless; while the arbitrage portfolio would have a beta equal to that of cash, i.e., zero, its return would have a very large standard deviation (in other words, beta does not capture the true risk of the arbitrage portfolio) and it discourages arbitrageurs. Second, many potential arbitrageurs may not know that the arbitrage opportunity exists, or do not believe it will persist over the time horizon with which they are concerned. At any rate, the low-volatility anomaly has persisted for decades despite the possibility of it being arbitraged away.