Investment Studies

Benchmarks as Limits to Arbitrage: Understanding the Low Volatility Anomaly

*Many studies over the years, including their 2010 paper titled Benchmarks as Limits to Arbitrage: Understanding the Low Volatility Anomaly, Malcolm Baker of Harvard Business School and co-authors Brendan Bradley of Acadian Asset Management and Jeffrey Wurgler of NYU Stern School of Business found that selectively investing in portfolios of either low-beta or low-volatility stocks over the 41-year period spanning 1968 through 2008 would have resulted in annualized alphas of 2.6% and 2.1%, respectively.  The swings these portfolios experienced were also far less extreme than those of the broader market.

The Volatility Effect: Lower Risk Without Lower Return

Based on the study, low-volatility and low-beta portfolios offered an enviable combination of high average returns and small drawdowns. This outcome runs counter to the fundamental principle that risk is compensated with higher expected return. We believe that the long-term outperformance of low-risk portfolios is perhaps the greatest anomaly in finance. Large in magnitude, it challenges the basic notion of a risk-return trade-off.

Blitz and van Vliet (2007) present empirical evidence in their paper, “The volatility effect: Lower risk without lower return” that stocks with low volatility earn high risk-adjusted returns (Blitz, et al., 2007).  The annual alpha spread of global low versus high volatility decile portfolios amounts to 12% over the 1986-2006 period.

Betting Against Beta

Frazzini and Pedersen (2014) demonstrate in their paper, “Betting against beta,” that the beta anomaly also exists in other classes such as bonds, currencies, and commodities (Frazzini, et al., 2014).  They also find that the beta anomaly exists in 19 other developed stock markets from 1989 to 2012.

Commonality in the Determinants of Expected Stock Returns

Haugen and Baker (1996) concluded that stocks with higher expected and realized rates of return are unambiguously lower in risk than stocks with lower returns, and the results seem to reveal a major failure in the Efficient Markets Hypothesis (Haugen, et al., 1996).

Quality Minus Junk

Clifford Asness, Andrea Frazzini, and Lasse H. Pedersen (2013) in their paper, “Quality Minus Junk,” define a quality security as one that has characteristics that, all-else-equal, an investor should be willing to pay a higher price for: stocks that are safe, profitable, growing, and well managed. They find that high-quality stocks have historically delivered high risk-adjusted returns while low-quality junk stocks delivered negative risk-adjusted returns (Asness, et al., 2013).

Re-Thinking Risk – What the Beta Puzzle Tells Us about Investing.

Cowan and Wilderman (2011) discus the anomaly in their paper “Re-Thinking Risk – What the Beta Puzzle Tells Us about Investing.”  They refer to it as the “beta puzzle”: portfolios of low beta stocks have historically matched or beaten broader equity market returns, and have done so with significantly lower volatility. At the same time, high beta stocks have significantly underperformed, exhibiting lower returns while appearing to take on much more risk (Cowen, et al., 2011).