The “volatility effect,” also known as the “low-risk effect,” is the subject of a new paper from Robeco. The gist of the “effect” is this: low-risk stocks “should” show a lesser return than high-risk stocks. The Capital Asset Pricing Model predicts a linear relationship between the risk of a security as measured by its volatility and its return. The idea is that investors will have to be bribed, so to speak, into accepting that higher risk.
David Blitz is the first-named author of the paper and head of quantitative research at Robeco, the Netherlands-based asset management firm that since 2013 has been a subsidiary of Japan’s Orex. The other authors are Pim van Vliet, the head of conservative equities are Robeco, and Guido Baltussen, the head of quant allocation at Robeco. Baltussen is also a professor of finance at Erasmus University, also in the Netherlands.
But they don’t have to be bribed
In fact, empirical evidence suggests that there may be more punishment than reward for accepting the high risk.
A study done in 2007 showed that over a 20-year period ending at that time (and thus a period ending short of the global financial crisis of the following year), the relationship of risk to return was not only flat, it was negative.
Other findings included that the volatility effect “is not only present in the US equity markets, but also in international equity markets.”
The volatility effect has persisted over time. One might reasonably have expected it to be arbitraged away. One implication, after all, is that higher risk assets are overpriced, because they don’t actually produce the return buyers are paying for. So why would a lot of traders not short the high-risk stuff, going long the low-risk analogs? And if they did that, shouldn’t their doing so bring prices on both sides more in line with CAPM?
That is a reasonable hypothesis. And a lot of betting-against-beta (BAB) does happen. But it hasn’t closed the supposed arb window. Yes, it may have seemed to be closing at one point, as the last millennium was ending. The factor premium you could get in this way in the 1990s was much smaller than the sky-high premiums available from BAB in the 1980s. Yet the size of the premium came roaring back in the first and second decades of the new millennium.
What's going on?
One theory, acknowledged in the Robeco paper, is that the gains one gets from BAB are really derived from a “profitability effect.” This is the argument made by Robert Novy-Marx of the University of Rochester in an NBER working paper in 2014.
The Robeco authors acknowledge this argument but disagree. At most they say the short side of a BAB strategy can be explained as the short side of the Fama-French profitability factor. But many investors take a long-only approach to BAB, and the strategy works for them. So obviously it cannot be explained by a reduction that only works on the short side.
There have been other explanations offered for the volatility effect in the literature. That literature is summarized by these authors as “the existence of leverage constraints, a focus on benchmark-relative instead of absolute performance, agency issues, skewness preference, and various behavioral biases.” They appear to believe that each of those considerations plays a part.
The Robeco paper further argues that the volatility factor has not be arbitraged away because many institutions have an enduring systemic basis in favor of risk. Mutual fund managers increase their exposure to high-risk stocks when they want to bet benchmarks, and they were doing so even when low-risk investing was becoming more popular in the late 1990s. Hedge fund managers, likewise and more emphatically, are on the other side of the low-risk trade. Hedge fund activity helps to sustain the anomaly, given their option-like incentive structures.
Even institutional investors for whom low-risk investing would be a natural fit may have been discouraged from fully exploiting it by the regulatory climate in recent years in which the same capital charges are applied to low-risk as to high-risk stocks.