One of the big problems for the first formal asset pricing
model developed by financial economists, the CAPM, was that it predicts a
positive relation between risk and return. But empirical studies have found the
actual relation to be flat, or even negative. Over the last 50 years, the most
“defensive” (low-volatility, low-risk) stocks have delivered both higher
returns and higher risk-adjusted returns than the most “aggressive”
(high-volatility, high-risk) stocks.
The literature provides several proposed explanations for the low volatility anomaly. The most prominent is that faced with constraints and frictions, investors looking to increase their return choose to tilt their portfolios toward high-beta securities to garner more of the equity risk premium. This extra demand for high-beta securities, and reduced demand for low-beta securities, may explain the flat (or even inverted) relationship between risk and expected return relative to the predictions of the CAPM model.
Regulatory constraints can also be a cause of the anomaly. Regulators typically do not distinguish between different stock types, but merely consider the total amount invested in stocks for determining regulatory capital requirements. Investors desiring to maximize equity exposure but minimize the associated capital charge are drawn to high-volatility stocks because they provide more equity exposure per unit of capital charge.
The academic literature has also
posited that constraints on short selling (such as charters prohibiting it) and
fear of unlimited losses can cause stocks to be overpriced because the
optimists are expressing their views by pessimists may be unable, or unwilling,
to do so.
And finally, the research
demonstrates that both mutual funds and individual investors tend to hold the
stocks of firms that are in the news more. In other words, they tend to buy
attention-grabbing stocks that experience high abnormal trading volume, as well
as stocks with extreme recent returns. Attention-driven buying may result from
the difficulty that investors have in searching through the thousands of stocks
they can potentially buy. Such purchases can temporarily inflate a stock’s
price, leading to poor subsequent returns. Attention-grabbing stocks are
typically high-volatility stocks, while boring low-volatility stocks suffer
from investor neglect. The attention-grabbing phenomenon is therefore another
argument supporting the existence of the volatility effect.
In fact, prior research demonstrating that companies that experience unusually high news flows experience shocks in their price volatility inspired David Blitz, Rob Huisman, Laurens Swinkels, and Pim van Vliet to study the relationship between media attention and the low volatility anomaly.
Their June 2019 study “Media Attention and the Volatility Effect” tested the following two hypotheses:
The low-volatility effect disappears for stocks with high media attention.
The low returns for high-volatility stocks are caused primarily by stocks of companies that appear most frequently in the news.
They took the total number of news articles per company as a sorting variable (the raw data) and then adjusted for market capitalization (larger companies are more likely to receive media attention). Their database covered the period 2000-2018 and included U,S., developed international, and emerging market stocks.
The following is a summary of their findings:
There is an increasing pattern between
volatility and media attention.
Media attention increases for stocks in higher
volatility groups, and volatility increases for stocks in higher media
attention groups—‘glittery’ stocks tend to be the stocks with relatively high
volatility, while the ‘boring’ stocks that the media does not write about tend
to have relatively low volatility.
For stocks with similar media attention, the
Sharpe ratios are the highest for low-risk stocks and monotonously decline when
volatility increases. This finding rejects the first hypothesis.
Within each of the five volatility groups, there
was no statistically significant difference in performance between the
low-media-attention portfolios compared to the high-media-attention groups.
This finding rejects the second hypothesis.
The findings were consistent across U.S.,
developed international, and emerging markets, and in various tests of
Blitz, Huisman, Swinkels, and van Vliet concluded:
Based on these findings, we reject that the attention-grabbing hypothesis explains the volatility effect. Of course, this conclusion relies on the assumption that the number of media articles covering a stock is a good proxy for investor ‘attention grabbing’.
The literature provides us with many possible explanations
for the low volatility anomaly, including this behavioral one—investor
overconfidence. Investors (including active fund managers) are overconfident. The
result of overconfidence is that we have a violation of the assumptions used by
the CAPM, which is predicated on rational information processing. The impact on
the volatility effect is that, if an active manager is skilled, it makes sense
to be particularly active in the high-volatility segment of the market because
that segment offers the largest rewards for skill. However, this results in
excess demand for high-volatility stocks.
While there are many possible
explanations, what does seem clear is that many of them come from either
constraints and/or agency issues driving managers toward higher-volatility
stocks. Given that there does not seem to be anything on the horizon that would
have a dampening impact on these issues, it appears likely the anomaly can
persist. In addition, human nature does not easily change. Thus, there does not
seem to be any reason to believe that investors will abandon their preference
for “lottery ticket” investments. And limits to arbitrage, as well as the fear
and costs of margin, make it difficult for arbitrageurs to correct mispricings.
The bottom line is
that low volatility has predicted low volatility and likely will continue to do
so. And while it seems likely that the constraints and limits to arbitrage will
allow the high volatility stocks to continue to underperform, whether the high returns
to low volatility strategies will continue to present an anomaly is another
question. One reason is that popularity leads to cash flows which can cause premiums
to either shrink or disappear. For those interested, I addressed this question
in my Advisor
Perspectives article of June 19, 2019.
As Chief Research Officer for Buckingham Strategic Wealth and Buckingham Strategic Partners, Larry Swedroe spends his time, talent and energy educating investors on the benefits of evidence-based investing with enthusiasm few can match. Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has since authored seven more books: “What Wall Street Doesn’t Want You to Know” (2001), “Rational Investing in Irrational Times” (2002), “The Successful Investor Today” (2003), “Wise Investing Made Simple” (2007), “Wise Investing Made Simpler” (2010), “The Quest for Alpha” (2011) and “Think, Act, and Invest Like Warren Buffett” (2012). He has also co-authored eight books about investing. His latest work, “Your Complete Guide to a Successful and Secure Retirement was co-authored with Kevin Grogan and published in January 2019. In his role as chief research officer and as a member of Buckingham’s Investment Policy Committee, Larry, who joined the firm in 1996, regularly reviews the findings published in dozens of peer-reviewed financial journals, evaluates the outcomes and uses the result to inform the organization’s formal investment strategy recommendations. He has had his own articles published in the Journal of Accountancy, Journal of Investing, AAII Journal, Personal Financial Planning Monthly, Journal of Indexing, and The Journal of Portfolio Management. Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television shows airing on NBC, CNBC, CNN, and Bloomberg Personal Finance. Larry is a prolific writer and contributes regularly to multiple outlets, including Advisor Perspective, Evidence Based Investing, and Alpha Architect. Before joining Buckingham Wealth Partners, Larry was vice chairman of Prudential Home Mortgage. He has held positions at Citicorp as senior vice president and regional treasurer, responsible for treasury, foreign exchange and investment banking activities, including risk management strategies. Larry holds an MBA in finance and investment from New York University and a bachelor’s degree in finance from Baruch College in New York.