Low Risk Stocks Outperform within All Observable Markets of the World is an interesting paper from earlier this year that I’ve belatedly got round to reading. Co-written by Robert Haugen, one of the pioneering figures in quantitative investing, it focuses on the low volatility anomaly, which is the evidence that low volatility stocks on average produce higher returns than high volatility ones
The low volatility anomaly goes against conventional financial theory, which states that more volatile stocks should outperform since they are riskier. Haugen was one of the first researchers to show decades ago that empirical data in the USA did not support this idea and data in this newer paper essentially updates that. It looks at 21 developed markets and 12 emerging markets since 1990 and shows that low volatility stocks have consistently outperformed in all of these.
Of course, the interesting question is why this anomaly persists. Haugen and his co-author Nardin Baker propose what is essentially a behavioural and agency-based explanation, revolving around perceived incentives for the investment management industry to favour more volatile stocks.
They argue that a more volatile portfolio increases the chance of a portfolio manager earning a large performance bonus, while more volatile stocks also essentially create more opportunity for them to impress their peers and supervisors with bold stock selection decisions. They also argue that to some extent clients prefer to hear portfolio performance explained through news-related events, which encourages managers to favour stocks that generate plenty of news coverage and thus provide interesting narratives. Collectively, this creates higher demand for high volatility stocks, bidding up their prices relative to low volatility ones and decreasing expected returns.
It’s an intriguing explanation and they find some anecdotal evidence to support it: Institutions typically have higher ownership in more volatile stocks, analysts tend to cover them more and they generate greater news coverage. I suspect that many people who have sat in on plenty of analyst and fund manager discussions will have some affinity for the idea.
The Quality connection
Another interesting aspect to the excitement explanation is that it fits with another market anomaly – the apparent outperformance of higher quality stocks. One would expect higher returns to be associated with lower quality firms, since investors need added compensation for the added risk of these stocks. But the reality appears to be the other way round and
Once again, the respective raciness of stocks may be the explanation. High quality companies tend to be dull and relatively predictable, while low quality ones are more newsworthy and have “lottery ticket” characteristics, which many investors may secretly prefer.
Given this, it’s not much of a surprise to note that there is quite a significant overlap between volatility and quality: Low volatility companies are often what would be considered to be high quality (although not universally) and vice versa.
You can quite easily see this if you look at the sector allocations for low volatility and quality funds. Low volatility stocks tend to come disproportionately from four sectors: Consumer staples, healthcare, telecommunications and utilities. The same four sectors – especially the first two – are also the ones that tend to be associated with quality stocks. Both approaches tend to be much lighter on sectors such as financials, technology, industrials and resources than the overall market.
The Buffett connection
All this ties indirectly to another interesting paper from a few months ago that I’ve finally read at the same time. Buffett’s Alpha examines Warren Buffett’s performance and concludes that it has come principally from a) buying high quality, low volatility, large cap stocks and b) being able to do this with leverage via the “float” that Berkshire Hathaway’s insurance operations generate from premium income.
In practice, I think this was already fairly well understood by anybody who had paid much attention to what Buffett does, but it’s useful to see it statistically supported. More importantly perhaps, it illustrates how some highly successful investors such as Buffett have succeeded as much by understanding and avoiding the investment industry’s biggest errors as by doing anything exceptionally complex of their own.