Tuesday, October 09, 2012

Confirmation of Low Vol Dominance

The Institutional Investor takes on the Low Vol effect. Their simulation for US stocks, where they used the top 3000 tickers, and created a LoVol portfolio using the bottom 20% ranked by volatility, and HiVol the top 20%. Here's the results:
January 1974 through November 2011, LoVol (portfolio) beats the index by 59 basis points a year on a compound basis... As for HiVol, its performance relative to the index is truly dismal: It underperforms by 592 basis points a year on a compound basis.
This helpful nugget is nested in a theory that defies comprehension: reconstitution. My brain hurts trying to conceive how this works, because they say things like
If we hold a stock that drops out of the universe, we will certainly be selling it at a relative loss, because the stock has failed to keep up with the other stocks. After all, it has lost its place in the top 1,000. In essence, the strategy requires that we sell low in this case, creating a drag on performance.
But in this example, the stock had already lost value; selling it in backtests creates no further loss. They then note:
When multiple stocks are combined in a long-only portfolio, their interaction actually causes the portfolio to have a higher compound growth rate than the weighted average compound growth rate of the stocks in that portfolio.
The authors note this "can be quantified using highly technical mathematics", and for a proof that E(x+y)>E(x)+E(y), it must be highly technical indeed.  But why bother with a 100 page proof using the Taniyama-Shimura conjecture when you can simply go long SPY, short its constituents, and laugh all the way to the bank. Arbitrage! Methinks they are confused.

 It's good to know the why, because without a good theory for what is driving the low vol effect, one is reasonably skeptical, and of course I have one in The Missing Risk Premium: Why Low Vol Investing Works. Remember: theory without data is bullshit, and facts without theory are trivia.


cig said...

Trivia can still be useful if it documents a repeatable pattern.

I'm told the precise mechanism of action of a number of meds is not particularly well understood -- they were just found to work to cure some ailment without too many side effects by chance or trial and error.

Theory is mainly a productivity enhancement that helps discovering related facts more efficiently compared to shooting in the dark in all directions until you get a hit.

Anonymous said...

Fair point but there's an important distinction. Facts without theory in a repeatable experiment, like medicine or the physical sciences, are different than facts without theory in finance.