A Survey of Low Volatility Theories

David Blitz and Pim van Vliet, both of Robeco, and yours truly wrote a paper outlining the various explanations for the low volatility effect, Explanations for the Volatility Effect: An Overview Based on the CAPM Assumptions. The aim wasn't to trash or champion any particular approach, though I'm sure our biases show (we aren't in lock-step on this, note Blitz here vs. my approach here, which has a subtle distinction).  As most papers on the low volatility focus on the data, often with very different motivations, we thought a paper addressing these various theories would be helpful.

In any case, we go over the following explanations:

• Leverage constraints
• Regulatory constraints
• Constraints on short-selling
• Relative utility
• Agents maximize option value
• Preference for skewness
• Crash-aversion
• one-period model
• Attention-grabbing stocks
• Representativeness bias
• Mental accounting

If you are new to the literature I think its very helpful, because it has lots of references on seminal articles in the various threads, and you should be aware of what the various theories argue. As Nietzsche said, if you know the why, the how is infinitely bearable.  

Is Low Vol Overbought?

Robeco's Pim van Vliet on whether low-volatility stocks are expensive:



Basically, he says that looking P/E ratios they are slightly expensive. His low vol fund has a P/E ratio similar to the average, but on a dividend rate, it's actually cheaper.

He argues that low volatility stocks have predictable performance based on valuation, so in today's trendy environment, it pays to have a nuanced approach.
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Value and Momentum Everywhere by Asness, Moskowitz, and Pedersen just came out in the Journal of Finance, 4 years after appearing on the SSRN. It's a great paper highlighting two important factors for any equity investor. Indeed, I'd surely have it on the reading required reading list for anyone in the business, alongside classics on value via Fama and French's 1992 paper, and Jegadeesh and Titman's 10 year retrospective on momentum.

An interesting argument is that value and momentum are, well, everywhere: currencies, country bonds, commodities, and of course, equities.  This suggests that, if you are a long-short investor (ie, zero beta to the index), you should really go broad when you are implementing these strategies.
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Then there's Pension Portfolio Choice and Peer Envy, also just published, which was Jacqueline Wise's dissertation back in 2006 or so (see pic right). She does a good job of discussing envy in investing, the theme of my book. She references the usual suspects in this space: Duesenberry (1949), Abel (1990), Gali (1994). I'm surprised she didn't mention DeMarzo, Kaniel and Kremer.

Her model generates the following result that I too find, namely that equity allocations are identical when people are envious.  She also finds situations where this equilibrium implies a higher equity allocation than in the base case. I would think, if you took this further, you would find that when trendy risky investments become popular, their expected return is actually negative.

The paper stops short of the bigger implication: there is no risk premium in such a world.  Further, if 'everyone' is buying a specific asset, it's expected return can be significantly negative in equilibrium.  Instead, she suggests that investors preferences can be materially different when looking at pension plans. True, but she could be stronger.

This reminds me of Feynman's explanation for why the mass of the election was constantly revised upward over decades after Robert Millikan's initial estimate:

Millikan measured the charge on an electron by an experiment with falling oil drops, and got an answer which we now know not to be quite right. It's a little bit off because he had the incorrect value for the viscosity of air. It's interesting to look at the history of measurements of the charge of an electron, after Millikan. If you plot them as a function of time, you find that one is a little bit bigger than Millikan's, and the next one's a little bit bigger than that, and the next one's a little bit bigger than that, until finally they settle down to a number which is higher.

Similarly, people find piecemeal application of envy relevant, but currently aren't going 'all-in' because it's too large a change from the consensus.  Instead, it simply explains little things, more and more little things. If you believe it's the truth, the benefit is that you will get to see more agreement over time, which is fun.
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Speaking of envy, Steve Wisdom points me to this observation on the Stockholm riots, another piecemeal application.  Immigrants aren't happy, but not because they aren't doing well in absolute terms, just that relatively, things are not so good:

[Swedish immigrant] finds it hard to be as thankful as his parents still are to his adopted homeland. "They compare it to Baghdad or Somalia," he said. "But we younger immigrants only really know Sweden, and we just compare our situation to the one around us."

So remember that. Immigrants today are happy for their change in situation. They children won't be so grateful if they stay in the underclass, and will vote to redistribute accordingly. That's why I'm not a big fan of the always-interesting Bryan Caplan's call for unrestricted immigration.
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BTW, if you think you're smart, see if you can tell which way the bars move in this video, a test of which generates a 60% correlation with IQ, higher than that for reaction times (40%).  It seems like a quick and easy way to administer IQ tests without worrying about cultural bias. If you're really smart, you'll understand that it's not a perfect predictor of IQ, or wisdom, so don't tell me about how this test is stupid because you are smart and don't do well on this test, because a smart person wouldn't make that argument.

Speaking of taboo topics, there's a big brouhaha for hedge fund billionaire Paul Tudor Jones after he mentioned, in a untaped supposedly off-the-record seminar, that women are underrepresented from 'macro trading' because children tend to divert their focus. Now, in many professions there are stark gender disparities and a strange thing in our times is that if one publically states this could be somewhat 'natural' all hell breaks loose.  This is the kind of thing that makes us moderns idiots, where any really public person can't say truthful important things if they violate the axiom of equality (ie, all human demographics have exactly equal innate preferences and abilities for any activity conceivable).

In Isaac Newton's day, his big secret was that he believed the Trinity wasn't true, and he had to pretend it was true to save his job.  That's a pretty small concession, practically, compared to the PC taboos of today.

 As a practical example, among the several good changes they've made to wrestling to get it back into the olympics (Please vote to save wrestling here!) was to increase the number of women's weight classes at the expense of men's weight classes.   There are at least 100 boys wrestling for every girl, why give them anything close to equal representation? Because it pleases some outsider's sense of fairness? Presumably, women like to wrestle as much as men, they just don't because of cultural norms  This is absurd.

RAFI's Low Vol, My Winning Lotto Ticket

Research Affiliates (RAFI) suggests that you can dominate simple low volatility portfolios by blending them with some fundamental metrics.  Specifically, value, cash-flow, dividends, and sales, combined into a 'fundamental value' metric, generates a 200 basis point return premium that can carry over into the low beta portfolio, all while generating 25% lower volatility. These are reasonable expectations.

I'm skeptical that dividends and sales add to the Sharpe ratio of this approach, but hey, at least it's four factors, not 40.  One of the bigger opportunities here is that  low volatility, is  correlated with other metrics associated with higher returns like higher cash flow, value, low probability of default, etc. That is, it's like if small cap stocks had low betas, then clearly one should merge the two factors because they both are good selection criteria.

But then, it's easy to reach too far, and much value destruction comes from trading too much, overfitting, and that's what this kind of approach encourages. So, it takes great discipline trying to improve the low volatility approach whilst not overdoing it. The 200 basis point bogey suggests RAFI has realistic expectations.

In this video, Fiefie Li (right) notes two reasons for the low volatility attractiveness.  First, Asness, Frazzini and Pedersen's leverage constrained investors. Second, her paper Agency and Institutional Investment, with Michael Brennan and Cheng on delegated investors maximizing excess (ie relative) returns.  Both papers suggests irrational rules of thumb create incentives for massive misallocations of capital, which implies selling low volatility funds should be a piece of cake.

Interestingly, Li taught at UC Irvine, the same place Harin de Silva of Analytic Investors got his PhD, and also low volatility maven Bob Haugen.  I would think this is a good place to look for personnel to help with low volatility.

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I bought a Powerball ticket for the $500MM lottery last Saturday, and was actually interviewed by a local TV crew when I bought my one ticket, and said something to the effect that $2 buys me several minutes of daydreams about buying ridiculous things (that $100k lake submarine in SkyMall magazine).  Later I discovered a better reason for my purchase. In the many-worlds interpretation of quantum mechanics, every quantum event happens. It's basically the only way many can reconcile the EPR paradox or Schrodinger's cat being alive and dead. All possible alternative histories and futures are real, each representing an actual "world" or "universe". Therefore, after buying that ticket, I actually won the $500MM jackpot in many of those universes. Unfortunately, in this particular universe I did not win the lottery, but, I can take comfort that many of 'me' did win, and my utility function somewhere among those universes is insanely high. For some reason, I'm not enjoying that as much as I should based on the math.

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A neat paper highlights that married couples have higher divorce rates when the woman earns more than the man. Interestingly  the hypothesis the authors give for this is 'gender identity', the idea that men and women think a man works outside the home, the woman inside, and there's a cost to deviating from this norm.  They never try to motivate why men and women might think that's a good way to frame things. That strikes me as rather hollow, a patently arbitrary tradition that makes  couples seem like stupid ciphers of sociological tides.

I think it's definitely true that men like women who make money, just not more than what they do, similar to what men say about intelligence (in speed dating surveys, men like their women smart, just not smarter).  I also think women feel their man is not as dominant, and thus less masculine, when they earn more than him, related to research showing women have more orgasms with wealthier men.  In either case, this highlights people are social animals, and so they don't maximize 'absolute wealth' but rather, something more contextual, which is often highly correlated with absolute wealth.

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It was a good week in wrestling, as the US hosted a match against Russia and Iran in New York City. While the US beat Russia pretty handily, and got killed by Iran, they had different teams for each match so it's kind of hard to compare Iran vs. Russia. I'm really excited by the young US wrestlers that won, especially Dake, Taylor, and Stieber.   Also, the international wrestling body elected a new president from Serbia, and hopefully he will be more effective than the last guy, who reportedly thought that wrestling was old enough to not need lobbying at the Olympics--wrong!  The first thing he did was implement new rules, most importantly, a cumulative score for the whole match, 2 points for a takedown, and two three minute periods.

Weekly Roundup

Jon Vol sent me a little email saying he has a blog post on Taleb, and that it got picked up by a Taleb fansite, where at the bottom it is classified as "Filed Haters || Tagged Falkenstein." I'm not just a Hater, but rather, a type that can be applied to others! I wonder what our distinguishing characteristic is in their eyes?

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 “Pride gets no pleasure out of having something, only out of having more of it than the next man.” C S Lewis, Mere Christianity 

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 Now that wrestling is trying to get back into the Olympics, they are considering getting rid of singlets! I'd say, it's about time. Singlets simply aren't cool, and if high school kids suited up like cage-fighters I think the sport would be more popular.

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 Heritage's dismissal of Jason Richwine is pretty rich indeed. To recap, he coauthored a study critical of immigration, basically saying that the new immigrants from Mexico would receive more benefits than generate in taxes. Someone looked up his 2009 dissertation, and it had the racy title 'IQ and Immigration Policy.'

 It's truly a taboo topic, as demonstrated by his Harvard thesis adviser and famous labor economist George Borjas saying 'I have never worked on anything even remotely related to IQ, so don’t really know what to think about the relation between IQ, immigration, etc.' The NLS panel data that Borjas studies all the time has an IQ proxy (AFQT) in there that is highly powerful in regressions, and he has to know this. He also knows that the subject is not good for one's career, so I understand why he has trained his mind to not think about it, but it's surely an elephant in the room.

 Interestingly, Edward Miller writes a lot about race and IQ, which is probably why he spent his career in an academic backwater. His seminal 1977 piece Risk, Uncertain and Difference of Opinion was really the first paper giving a theory as to why risk and return are inversely correlated, and was the first person to state in a journal one should invest in low beta/volatility stocks for this reason.

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If you can read Dutch, there's a new review of my book The Missing Risk Premium out there in a CFA magazine. I can copy, paste into a translator, and get a broken English translation that is good enough.

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Weekly Roundup

If any of you are puzzled by the low inflation rate, consider that in 2005, the Fed convinced themselves that house prices weren't in a bubble because a hedonically adjusted housing price index showed little movement. Sort of like our consumer price indices.  From a Federal Reserve meeting that focused on home price appreciation circa 2005:

For example, over the four years from 2000 to 2004, the OFHEO index increased at a compound annual rate of 8.2 percent, while the constant-quality index increased at a 5.4 percent annual rate. As shown in exhibit 4, the current ratio of price over median family income derived from these two indexes is vastly different. If the OFHEO index is giving an accurate picture of what is happening to home prices, I think one could say with some confidence that prices have been bid up to unsustainable levels. However, if the constant-quality index is a better reflection of reality, home prices actually look somewhat low relative to median family income, particularly compared to the late 1970s. I believe the constant quality index provides a more accurate indication of what is happening to the price of a typical single-family home. In contrast, the OFHEO index is subject to upward biases that accumulate over time and distort ratios such as price-to-income and income-to-rents.

Clearly, that real estate adjustment wasn't helpful. Perhaps our current CPI is similarly biased? That is, if you used 1990's CPI methodology, inflation would be around 5%, and using 1980's, it would be 10% (see here). Were we wrong then, or now?
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Joseph Stiglitz has the following take-away from current events:

The big lesson that this crisis forcibly brought home—one we should have long known—is that economies are not necessarily efficient, stable or self-correcting.

Gee, that's what the latest data say? He has been saying that since he edited Samuelson's papers in 1970: markets are not efficient.  His life's work has been on that theme, as his Greenwald-Stiglitz theorem posits market failure as the norm, and his Sappington-Stiglitz theorem suggests that an ideal government could do better running an enterprise itself than it could through privatization.

I've never seen him seriously address government failure, other than the stupidity of IMF personnel, who he noted were rarely top students from Harvard, Oxford, or Princeton. If he thinks second-rate Yalies have negative productivity, what about your typical bureaucrat?

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Niall Ferguson's remark that Keynes's childlessness influenced his dismissive perspective on the long run created quite a firestorm, including a rather pathetic apology that will only encourage his enemies.  I remember reading a Keynes biography around 1988 and the author's theme was that homosexuality was the key to why Keynes thought 'outside the box.'  I personally doubt his homosexuality was so tenuously related to his economics it's hardly worth much thought, though perhaps it would rise to be worthy of an aside at a luncheon.

Diversity is supposedly this great thing because various minorities have different perspectives, why demographics have systematic predilections towards various parties and issues.  It seems a matter of pure logic to accept that if  different backgrounds can generate positive attributes, some could be negative, but if you ever say that you are a bigot.

I'm not anti-gay, and sympathize with their uniquely difficult coming out issues.  Yet, I'm not sympathetic to the idea that if one asserts any negative consequence of being gay, it's homophobia. I see this as an example of the Left showing its power and making sure that issues it categorizes as taboo stay taboo.
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The latest low volatility continue to show the benefits of low volatility this year.

Any way one would make a low vol portfolio--volatility, minimum variance algorithm, beta--generates the same results. See betaarbitrage.com for the data.

Asness, Frazzini and Pedersen have an important paper countering Ronnie Shah of Dimensional's assertion that low volatility is an industry result. It isn't.

Kevin Simler has some thoughts on the economics of status.  He basically argues it's very important and omnipresent. Never mentions the effect on risk premia, though I expect he wouldn't go that far.    That is, status seeking is accepted by economists at explaining parochial things, but somehow it disappears when it comes to addressing risk premiums, or welfare analysis.