Monday, February 20, 2012

Low Vol Commodity Timing Strategy

Perez, Fuertes, and Miffre present a paper highlighting that lower volatility is associated with higher returns in general. Looking at he 1992-2011 period, the commodity futures with low volatility outperformed those with high volatility by 4.6%. The effects appears independent of momentum and contango/backwardization effects.

I doubt this finding is truly a good investment strategy because while really highly volatile assets have low, often negative returns, they have such high volatility they should simply be shunned: a 0.1 Sharpe strategy is a bad long AND short. Nonetheless, a good prejudice for any investor should be that highly volatile assets and times are not good times to be long.

This is now the stylized fact of asset markets: higher risk implies lower returns. As a first approximation, it is true. There has been incessant criticism of the efficient markets hypothesis, and Black-Scholes option formula, but I find these theories pretty successful in their non-caricaturized versions. However, the risk-return theory underlying the CAPM, and its spawn the Arbitrage Pricing Theory or the Stochastic Discount Theory, is not just totally vacuous, it seems to usually have a sign error! It is not correct as an approximation. In contrast, Black-Scholes gives decent Greeks given an implied volatility, and consistent with the efficient markets hypothesis, it is hard to outperform passive indices.

These researchers have so imbibed the academic Kool-aid they state the the academic financial equivalent of 'furthermore, I think Carthage must be destroyed', with this aside:
This serves to extend the evidence of Ang et al. ...that the explanation for the observed profitability of idiosyncratic volatility strategies may lie in a yet-to-be- specified macroeconomic or financial factor.
That is, as risk must explain persistent returns, the only theory that makes sense to these savants is that that there's some risk factor that is like the stock market but actually inversely correlated with it (and thus, positively correlated with the relative returns of low-volatility equities and commodities). It must be subtle enough to escape notice of thousands of research academics for 50 years, and powerful enough to affect equities and commodities cross-sectionally. The thought that such a solution is possible highlights you simply can't falsify a framework like modern asset pricing theory. Further, there's so much strained hope in this view of the world that it puts delusional lottery ticket buyers to shame.

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