Wednesday, March 20, 2013

A New Low Vol Theory

Value and Size are common strategies based on the higher-than-average return to value and small cap stocks, and one can mention the value or size 'factor' that presumably causes this to happen without much explanation. It's a 'risk' factor to many, because small cap and value stocks generate statitical out-performance, which can only persist if there is risk associated with it.  As to what the risk of small cap and value stocks is, no one really knows. At first, it was thought to be financial distress risk, but then we discovered such firms have low returns when you measure distress directly, so that's not it. It's not volatility, or beta.

While I'm skeptical there's a good risk factor story for value and size, there's something intuitively spookier about value and small caps vs. their opposites, so I wouldn't shut the door on that.

In contrast, attempts to explain the low vol premium as a risk factor are like a socialist explaining the Stalin-Hitler pact, convoluted and unconvincing.  A paper by Li, Sullivan, and García-Feijóo on the SSRN looks at the feasibility of trading the volatility anomaly. As with Baker, Bradley, and Taliaferro (2013), they focus on 'abnormal returns', which I don't find as informative as simple absolute returns for various reasons, so I wont get into what they considered their main result. Instead, I want to talk about their mention of why there's a low volatility premium. Here's the first suggested explanation they offer for the existence of the low volatility anomaly:
Should the anomaly be related to systematic risk, then the excess returns can be viewed as arising from some, as of yet unknown, common risk actor(s). For instance, Merton (1987) offers an explanation for why investors would demand higher returns for taking on higher IVOL.
This is funny. They suggest one theory is that volatility demands a premium because it's risky when it's low (presumably, the CAPM beta holds as well, generating high and low risk to volatility as a factor, which, when you add a preference positive skew and aversion to negative skew, implies a great deal of nuance).  Then they reference Merton, who's hypothesized back in the old days (1987) that idiosyncratic volatility was positively related to risk because idiosyncratic volatility should contain a lot of mismeasured risk factors. As a potential taste of why the low volatility anomaly exists, its not promising because it's got the wrong sign.

Then they mention Ang, Hodrick, and Xing and Zhang (2009), who note the international dimension of this puzzle suggests perhaps a pervasive risk factor (they were really that tentative) That is, low volatility did relatively well in the 2008 crash, relatively poorly in the 2009 rebound, worldwide, so, it's correlated internationally, which means there's potentially a risk factor that they are all reacting to.  Just to be clear, the Low Vol 'risk factor' went down a lot in 2008, and was really high for most of 2009, which I guess means the low vol risk factor is like the two-slit experiment in quantum physics: if you think you understand it, you don't understand it.  .

 I guess they were simply trying to survey prominent outstanding explanations, but I think this is like introducing your new theory on influenza with an overview of the various goblins hypothesized to cause colds.  And indeed Li, Sullivan and García-Feijóo prefer their own new theory of market mispricing, which though in working paper since 2010 isn't on the internet, so who knows. Interestingly, while they mention Black (1972), making one think, this is a leverage story, they then mention Wurgler, Baker, and Bradley  (2011) and only mention Asness and/or Frazzini and Pedersen in a different context, implying, they really think it's not a leverage story, just some, well, mispricing story that's affected by all the things that keep rational people doing what economists think they should want to do.

I'll keep an open mind until I read it.


Mercury said...

Value isn’t spookier so much as growth is sexier and humans are (on average) suckers for sexy beyond what is rational.

Picking stocks is about regression to the mean in the sense that you want to buy discounted future cash flows at a discount so that when the market price for those cash flows reverts to “fair” value, you make money. Even if that doesn’t work out as planned in any particular name, it should work out on average across an appropriately sized group of names with decent diversification.

When making such assessments about future cash flows value investors favor past cash flow track records as a guide and growth investors favor a bunch of other, assumption-heavy stuff as a guide. Not too surprisingly the past turns out to be a bit better predictor (on average) of the future in this regard than various combinations of other stuff and as a result value has outperformed growth since the 1920s (before and after the ’29 crash I think).

This value/growth performance gap persists because we’re talking about human beings here and human beings like sexy. The future is sexy (or it used to be anyway) and the past isn’t. What is sexiest of all in stock investing is to identify those very few growth companies that actually deliver in a big way –and for a decent stretch- on the future growth part (Polaroid, Dell, Apple etc.).

Those kinds of future growth prospects, like the prettiest girls, get a lot of attention even though most everyone knows that on paper you have a better chance (less alpha and luck required) of long-term success loading up the portfolio with a bunch of proven 7 1/2s instead of chasing the hope-to-be 10s. Sexy gets a premium in the market but that premium is also a greater height from which to fall when those future cash flows don’t (on average) quite materialize...and that leads to underperformance vs. value over time.

Eric Falkenstein said...

I think you are right to characterize Value as more of anti-growth, anti-sexy.

Anonymous said...

@ Mercury:

So why doesn't this get arbitraged away? Money management is largely institutionalized nowadays, successful funds attract most of the flows, so investors who continue to make the same errors of judgment should be pushed out of the system at some point. But the value anomaly persists, so it seems there's more going on than just this sexy/unsexy story.

Mercury said...

I think it still boils down to time and the human element. Value can and has underperformed Growth for long stretches. So, if you put on some sort of position where you swap the Growth return for the Value return you could be under water for longer than you (or your investors, trustees etc.) are willing to take the pain.

People's lives are constrained by time obviously so they tend to get impatient, focus on last Q's returns and become swayed by arguments that "this time is different". I'm sure there are even more confounding contradictions/anomalies turned up by the rapidly developing field of econometrics all the time. Value equity is still one of the best asset classes for endowments and other pools of assets that are less time constrained but alas, those are controlled by fallible humans as well.

Shall I send you a brochure? :)

Anonymous said...

I think we might get a bubble in low vol/high cash flow stocks!

Adding low cost leverage (thank's Ben!) to the strategy is just too tempting.

Robert Michel said...

We already have a bubble in high dividend stocks. E.g. Students Transportation, Linn Energy and Veresen Incorporated are absurdly overpriced.