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Q&A with IFA: Do Low-Volatility Strategies Produce High Returns

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Question: Certain researchers have reported1 that low-volatility stocks in the U.S. outperform high-volatility stocks and attribute this apparent anomaly to investor behavioral biases as well as limits to arbitrage. What do you make of their argument?

Note: The question above was taken from DFA’s Fama/French Forum. Here is their response:

“It is just that, an argument. We have known since the '70s that the relation between beta and average return is much flatter than predicted by the CAPM. Their measure of total volatility is highly correlated with beta. They give a behavioral story, but other stories are consistent with their results. In any case, the CAPM has other more serious problems, and we think a multifactor model is necessary to capture, for example, the value premium in average returns, which shows little relation to beta.”

It seems to us that this question stems from the eternal but ill-founded desire to get high returns without high risk. One key point of Fama and French’s multifactor model is that taking on additional risk in the form of size (tilting towards small cap stocks) or value (tilting towards value stocks) does not necessitate a proportional increase in volatility. Nevertheless, investors should still consider it risk, and they should never fall into the trap of thinking that they are getting something for nothing.

Fama and French correctly point out that low-volatility strategies are functionally equivalent with low-beta strategies. Beta is a measure of sensitivity to the overall market, which by definition is assigned a value of one. For example, a portfolio with a beta of 0.8 would be expected to go up by 0.8% on a day where the market gains 1.0%, assuming that beta is the only relevant risk factor, which it is not. Value stocks tend to have lower beta (and volatility) than growth stocks, but that does not mean that they are lower risk.

Dimensional Fund Advisors (DFA) has done extensive research on this topic. An article2 they posted in August, 2011 stated that while low volatility portfolios had similar returns with the overall market but with lower standard deviation over the period 1968-2010, their gain in performance was attributable to industry bets and value tilts. Similar risk-adjusted performance was attainable with a globally diversified portfolio of equities combined with low-risk fixed income. Regarding industry bets, IFA has consistently advised investors to steer clear of them. The author of this article states that investors who pursue a low-volatility strategy may simply be trading market risk (beta) for value risk.

DFA’s second article3 on this topic found that a large number of high volatility stocks come from the small growth segment of the market. As seen in the chart below, this segment (SG) has the lowest return per unit of risk, so underweighting a portfolio with respect to small growth would impart a higher risk-adjusted return than the total market.

Furthermore, high volatility stocks tend to have negative momentum, which indicates a lower expected return. In all of its funds, DFA avoids buying extreme small growth and negative momentum stocks. Thus, whatever performance increase that can be attained by a low volatility strategy is likely to be captured by investors that are advised by Index Fund Advisors. If you would like to learn more about IFA’s approach to investing, please call us at 888-643-3133.

1Baker, Malcolm, Brendan Bradley, and Jeffrey Wurgler. "Benchmarks as Limits to Arbitrage: Understanding the Low-Volatility Anomaly." Financial Analysts Journal 67, no. 1 (January–February 2011).

2Shah, Ronnie R. “Understanding Low Volatility Strategies: Minimum Variance.” Dimensional Research, August 2011.

3Crill, Wes and Shah, Ronnie R. “Residual Volatility and Average Returns.” Dimensional Research, December 2012.