From Research Affiliates:
True Grit: The Durable Low Volatility Effect
One
of the basic tenets of finance is that investors are compensated for
taking risk. For equity markets, that means that high volatility stocks
are expected to outperform low volatility stocks. But that hasn’t
happened. Low-risk stocks have historically outperformed high-risk
stocks.
Will
this low volatility effect persist? Renewed interest in low volatility
strategies has led to higher demand for low volatility stocks, and high
demand for low volatility stocks could conceivably eradicate the return
premium once and for all. Nonetheless, the effect has proven robust
across time periods and markets, and, unless contrarian investing
paradoxically becomes the norm, there is good reason to believe that it
won’t go away anytime soon.
Historical Record
The low volatility effect has been known so long1
and studied so extensively that there is little danger it will be
discredited as a statistical fluke or a by-product of incomplete or
erroneous data. Low volatility stocks tend to trade at a discount to the
broad market and, of course, to high volatility stocks; the magnitude
of the discount is highly variable,2 but the low volatility effect has nonetheless been durable (see Table 1).
The fact that simulated low volatility strategies have produced excess
returns in many countries implies that the effect is deeply embedded in
global capital markets.
The
historical record, then, is reassuring. Nonetheless, we’ve all seen
rapid, even cataclysmic, change in other situations. Institutional
arrangements can break down, technological advances can disrupt the
balance of power, regulatory reforms can impede capital flows or raise
the cost of trading, and, in principle, people can learn from
experience. Even if we resolutely assume that radical change is
unlikely, we cannot offer an opinion on the continuance of the low
volatility effect without understanding the conditions that have made it
possible thus far.
Revisiting Risk and Return
Riskier assets have higher expected returns.
That
statement might be considered too categorical in academic circles, but
it is an article of faith in active portfolio management. Investors are
rewarded by profits for risking their capital just as hourly workers are
compensated by wages for committing their bodies and minds to
economically productive activities. And, considering that wage-earners
get more pay for putting in longer days, investors quite reasonably
require higher rewards for taking on more risk. John Stuart Mill (1885,
p. 107) vividly expressed the idea: “The profits of a
gunpowder-manufacturer must be considerably greater than the average, to
make up for the peculiar risks to which he and his property are
constantly exposed.” Rates of return are a straightforward function of
risk, and rational investors set their expectations accordingly.....MORE
HT:
Abnormal Returns
