Sunday, October 21, 2012

Merton vs. Low Vol

Low volatility investing is becoming more popular, but the question is perhaps it could be better captured via a more inclusive metric of volatility. The Merton model of default popularized by Moody's KMV is basically a function of two inputs: volatility and leverage. If this model is correct, then a probability of firm failure is better captured than mere volatility alone, and perhaps it also captures the true, fundamental volatility that is driving the low vol effect. 

I took data on the distance-to-default (DD) that I calculated monthly using the standard approach (I used to work on default models at Moody's), and this isn't really ambiguous: anyone in the know can generate them. I then looked at the top 1500 stocks by market cap, and formed portfolios with the highest volatility/lowest distance-to-default, and those with the lowest. Remember that low distance to default means 'risky', high DD is low risk. It turns out the portfolio returns generated from this exercise were so similar, the low volatility/high distance to default portfolio lines are indistinguishable.

It seems for the purpose of predicting future equity returns volatility and the Merton model are synonymous.  


Hans Betlem said...

You might want to take a look at the work of SocGen analyst Andy Lapthorne who constructed a Dividend & Quality index. He tests for quality with the DD model and Piotroski. He, then, adds dividend yield requirement of 4%. His index outperforms LowVol only.

Anonymous said...

did you equal weight the various portfolios to get the results above? Also, does the standard approach assume the same recovery rate for each stock?

Anonymous said...

"Andy Lapthorne who constructed a Dividend & Quality index. His index outperforms..."

Gee, ya think anyone out there is already overweight dividend-payers? How about high-quality?