In our society, the concept of risk and reward is inherently linked. From the earliest age, we are exposed to stories where taking a greater chance results in success. Slogans like “No Pain, No Gain” or “No Guts, No Glory” are used in almost any context you can think of.
People like Richard Branson, who has taken both physical and financial risks on his way to becoming a billionaire, are examples of bold individualists whose stories have inspired the masses for generations. Part of the appeal in investing in tech stocks like Apple and companies like Dell and Microsoft in the nineties was the stories and the people behind the companies.
In equity investing, the concept of greater risk for greater reward has had strong appeal. Those who brave more volatility are ultimately rewarded for their efforts. The plane ride is bumpy but the destination is worth it. If one looks at the way financial products are sold, categories such as “Aggressive”, often linked to higher volatility funds seem to reinforce such thinking. Recently, however, there has been a lot of study into which strategies actually generate the best risk adjusted returns, and the result is a number of new investment products based on low volatility strategies.
The Missing Risk Premium
In The Missing Risk Premium: Why Low Volatility Investing Works (2012), author Eric Falkenstein takes dead aim at some of the most cherished assumptions academia has churned out over the last fifty years. Falkenstein, who wrote the well-received Finding Alpha in 2009, delves into many of the reasons why the Capital Asset Pricing Model and the nature of the Equity Risk Premium have seldom been challenged on any front over the years.
The author cites many types of wagers where the standard risk/reward assumptions give way to the fact that those who take stupid risks generally are obliterated. He divides asset classes into three categories; those that carry positive risk premium such as the short end of the yield curve, those with a zero risk premium, and finally speculations that carry a negative risk premium. Among the asset classes fitting the latter category are penny stocks which he characterizes as little more than lottery tickets. He also notes the favorite/longshot bias in horse racing which has been discussed here on numerous occasions. Out of the money call options are another example as aggregated results show that riskiest and farthest out of the money plays generate the worst return.
The following table illustrates the Favorite/Longshot bias at North American thoroughbred tracks using a database I maintain for the time period of July 1, 2011 to June 30, 2012. As can readily be seen returns steadily drop the higher your odds.
Odds Category |
TOTAL |
WPCT |
$2 WNET |
0.05 To 01.00 |
15,228 |
50.63% |
1.70 |
01.05 To 03.00 |
67,098 |
28.15% |
1.67 |
03.05 To 05.00 |
56,571 |
16.49% |
1.62 |
05.05 To 10.00 |
83,568 |
9.84% |
1.58 |
10.05 To 20.00 |
74,349 |
5.13% |
1.50 |
Gr Than 20.00 |
96,059 |
1.71% |
1.19 |
|
392,873 |
12.63% |
1.49 |
Ultimately, Falkenstein makes the argument using data over the last half century that low beta investing has outperformed high beta investing, allowing investors to achieve superior returns with less risk. As was the case in Finding Alpha where he applies the concept of alpha to all aspects of life including career; Falkenstein delves into the complexities of modern life that resist the restraints that relatively simple models put on them.
A key argument in his book is for a relative utility model, or as he states, people tend to behave in reaction to feelings of envy as opposed to greed. This has been pointed out in happiness studies where people usually compare themselves to those around them. Thus, if you made twice the median income and everyone you worked with made four times the median income you might not be as satisfied with life as you would be if your peer group was different. Falkenstein argues that people make decisions every day that do not conform to the expectations of a greed based model of thinking.
Falkenstein maintains a blog at falkenblog.blogspot.com that gives potential readers insights into his ideas. There is also a link to his web page which contains more information on the book as well as videos that summarize some of the main themes of his previous book Finding Alpha and a short summary of The Missing Risk Premium. The new title is also available for Amazon Kindle for under ten dollars and as of late October was available as a rental for Amazon Prime members.
Buffett and Low Volatility
An interesting recent study by principals at New York University and AQR Capital Management traced much of Warren Buffett’s statistical outperformance to a combination of low beta stocks and the use of leverage. The leverage noted in the study was 60% of capital or 1.6. The period that was looked at was 1976 to 2011.
It is well known that Buffett is a buy and hold investor, focusing on high quality earnings and superb management. What has also been noted is that as such he avoids the high octane, popular “story” stocks that studies have shown subpar returns. In industry choice, he has avoided sectors that require the constant innovation that shortens the dominance of successful companies.
The unique nature of Buffett’s insurance operations has long been commented as synergistic to his investing skills. Money from insurance premiums is available to invest before it is needed to pay out claims. Buffett didn’t come to the insurance business by accident so his ability to take advantage of the economics of the business can also be termed a tribute to his abilities as an asset allocator.
The study, entitled Buffett’s Alpha, was available via a link on the CFA Institute website as of early November and is a very worthwhile read, for those interested in examining the ideas behind the conclusions.
So, can you reproduce Buffett’s fortune with a robot portfolio and leverage? Probably not, if one looks at his lifelong track record, or even pieces of it. For twenty years, we have seen pundits, strategies, and even mutual funds falter that have promised to reproduce Buffett’s success. Understanding what kinds of risks have been rewarded, however, is still extremely useful. It should also be noted that the structure of Buffett’s business operations and his borrowing costs never put him in a situation where leverage burns him.
As the paper suggests, one explanation for the success of low volatility investing is “leverage aversion”. Some market participants are constrained in their ability to leverage trades and thus resort to high beta stocks to compensate, or overpay for derivatives and prepackaged leveraged finance products. Others are unwilling to use leverage and gear towards higher volatility strategies in an attempt to generate higher returns.
Exchange Traded Funds (ETFs)
BlackRock’s iShares division has a number of index products based on Low Volatility strategies. These include the MSCI USA Minimum Volatility Index Fund (USMV) which carries a total expense ratio of 0.15%. The underlying index the fund uses is the MSCI USA index, which according to the fund’s prospectus seeks to find United States listed equities in the top 85% by market capitalization with lower volatility. The fund has been in operation for less than a year and according to Morningstar has an annual turnover ratio of 30%.
iShares also has a number of different ETF Low Volatility products in different sectors including the MSCI All Country World Minimum Volatility Index Fund (ACWV), MSCI Emerging Markets Minimum Volatility Index Fund (EEMV), and MSCI EAFE Minimum Volatility Index Fund (EFAV).
The market leader in the low volatility category is PowerShares S&P Low Volatility ETF (SPLV). Launched in 2011, the fund sports an expense ratio of 0.25% and an annual turnover of 12% according to Morningstar. It tracks the S & P Low Volatility Index, which monitors the performance of the 100 least volatile stocks in the S & P 500 over the last year. According to Standard and Poors’ website, volatility is calculated as standard deviation of daily returns over the last 252 trading days. As of September 30th, almost 60% of the fund was invested in the Consumer Staples and Utilities sectors.
PowerShares also has other products in its low volatility family including the PowerShares S&P Emerging Markets Low Volatility Fund (EELV) and the S&P International Developed Low Volatility Fund (IDLV).
Caveats
The recent explosion in quantitative and technological advances has led to the realization of a number of different strategies that would have been successful over the last 50 years. The advantage investors who have been successful employing these strategies have had is that they inherently understood their advantage before the competition. When employing these strategies in the future one must account for the fact you now have a lot of company.
Conclusion
In this article, we highlighted some recent literature that supports the conclusion that low volatility investing offers better returns with less risk. We also took a brief look at some current products available in the marketplace that allow individual investors to apply the strategy.
