Half a century ago, it became clear that investing in higher risk equities is not necessarily rewarded with higher returns. This low volatility anomaly goes against the traditional belief that there should be an extra reward for taking more risk. The anomaly persists to this day. There is now a range of investment strategies seeking to capture the benefits of the anomaly, including our own.
It can be considered an anomaly that stock returns do not increase with volatility (more volatility being seen as reflecting investor concerns over, for example, upcoming results and the strength of the issuer’s balance sheet). Intuitively, you would expect high-volatility stocks to offer investors a higher compensation for that increased risk. However, empirical evidence has shown over and over again that this is not the case, in particular over the medium to long term.
The phenomenon was first reported by Robert Haugen and James Heins. In a December 1972 paper entitled “On the Evidence Supporting the Existence of Risk Premiums in the Capital Market”, they analysed the performance of US stocks between 1926 and 1969.
Too controversial at the time, the paper was not published until December 1975 in the Journal of Financial and Quantitative Analysis in a revised form and under a new title: “Risk and the Rate of Return on Financial Assets: Some Old Wine in New Bottles”.
Low volatility has since been widely studied and debated in the financial industry. It has been extended to other asset classes. For example, in 2014, in “Low risk anomalies in global fixed income: evidence from major broad markets”, we showed that such an anomaly can also be found – to a varying extent – everywhere in fixed income markets.
Low volatility anomaly – the origins
Several possible explanations of the anomaly have been proposed over the last 50 years. They tend to be based on the observation that investors typically prefer higher-risk stocks for a number of reasons that are not taken into account in basic financial theory.
The first explanation was offered by Fischer Black, Michael C. Jensen and Myron Scholes in “The Capital Asset Pricing Model: Some Empirical Tests” published in “Studies in the Theory of Capital Markets” in 1972. They showed that constraining the amount of leverage investors can use creates a preference for higher-risk stocks. This should result in lower returns than otherwise expected for the same level of risk, i.e. in a low volatility anomaly.
The second explanation involves the notion that not all investors seek to maximise absolute returns and reduce volatility as it is required for returns to scale with risk.
Indeed, most professional fund managers are assessed on the excess returns and risk they create against market capitalisation benchmark indices. Moreover, the remuneration of fund managers is often asymmetrically linked to those excess returns, i.e. there is strong upside potential in the case of outperformance, but limited downside in the case of underperformance. This incentivises them to take risk and prefer higher-risk stocks.
Finally, behavioural theory challenges the notion that information is complete and rationally processed, as required for returns to scale with risk.
Indeed, the vast majority of investors, even professionals, is affected by the same cognitive biases that affect everyone else such as the biases relating to representativeness[1], overconfidence[2] or a preference for lotteries.[3] These biases have been associated with a preference for riskier stocks, even if there is no added reward for the extra risk.
Such misconceptions can lead to the low volatility anomaly.
Proprietary research
Our research has shown that the least volatile stocks in every equity sector have a higher Sharpe ratio than those of the riskier stocks in the same cohort. In other words, the low volatility anomaly was found to be omnipresent: It is not confined to sectors typically viewed as less volatile such as utilities, consumer staples or healthcare.
A decade after launching our global low volatility equity strategy[4], we revisited our research to ascertain if our initial analysis still held true. As we explain in “The low volatility anomaly in equity sectors – 10 years later!”, the answer is a resounding ‘yes’.
The results defy the notion that once an anomaly is discovered, it tends to be arbitraged away. In our view, the low volatility anomaly is alive and kicking.
This is part 1 of a mini-series marking 50 years since the discovery of the low volatility anomaly. Parts 2 and 3 will cover evidence of the anomaly and implementing it in practice.
Further reading
A low volatility equity strategy that can resist rising rates and inflation
The low volatility anomaly in equity sectors revisited
References
[1] See https://corporatefinanceinstitute.com/resources/wealth-management/representativeness-heuristic/
[2] See https://corporatefinanceinstitute.com/resources/wealth-management/overconfidence-bias/
[3] See https://www.spring.org.uk/2022/11/availability-heuristic.php
[4] Parvest Equity World Low Volatility, launched in March 2011, has become BNP Paribas Sustainable Global Low Vol Equity effective September 2019. For illustrative purposes only. Past performance is no guarantee of future performance.
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