Low Risk, High Rewards: The Low Volatility Anomaly

Axiomatic Memes

It’s an axiom of standard economics that you don’t get above average returns without taking above average risks. No risk, no reward.  It’s an appealing idea, an extension of the entrepreneur's creed: you don't become successful without taking chances.  It’s a meme that’s gone viral, an idea that permeates discussions about investment, drives hard headed analysis and leads us to celebrate the risk taking achievers in society.

And of course it’s a bucketload of hogwash. In fact, lower risk portfolios will tend to outperform higher risk ones.  High risk stocks are dangerous rubbish, and offer not excess returns but excess losses.  They’re a one way ticket to the seedy side of the market.

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Death of the Accrual Anomaly

Surprise, Surprise

Company earnings are, you’d have thought, a pretty straightforward measure of a company’s health. After all, earnings are a statement of profits, are they not? Of course this is finance and, therefore, nothing is quite as it seems.

You see earnings are not necessarily cash and contain a mysterious component called accruals, the calculation of which keeps accountants the world over gainfully employed. Companies that rely heavily on accrual based earnings tend to have more earnings surprises and this anomaly is exploitable by investors: or at least it was, until it mysteriously vanished.

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Exploiting the Anomalies

Less Guts, More Gain

Given that it’s well established that people are behaviourally biased and that market prices are impacted by these biases you might think that it ought to be possible to profitably trade on the underlying anomalies that these generate. However, by and large, it seems that this doesn’t happen, either because the anomaly vanishes as soon as it becomes widely known or because it’s not actually possible to trade on the thing for one technical reason or another.

If this is the case then behavioral finance ends up being an interesting research area but one that’s difficult, at least for ordinary mortals, to exploit other than through the tried and trusted means of learning to ignore the instincts of our guts. Still, as you might expect there are people out there seriously looking at whether there are profitable trading strategies that might be exploited. The slightly surprising answer seems to be that there are.

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Do Behavioral Funds Work?

No. Maybe.

For all the impressive research on behavioural finance the acid test is ultimately whether it can yield better returns for investors. A few intrepid souls have set out to discover whether there’s any evidence that investing along behavioural lines can produce such returns and have re-emerged from the mutual fund jungle, somewhat battered and worse for wear, with the broad answer of, err, “No, it doesn’t”.

Of course, there’s a bit of a puzzle behind the research because the concept “behavioural investing” is somewhat amorphous. It would be unsurprising, given the parasitic mutational qualities of the financial sector, if the rise of behavioural finance didn’t attract managers who see it as the next destination of hot money. It’s enough to make your head spin: behavioural finance itself could be the next behavioural finance anomaly.

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Volatility, the Last Anomaly

Jitterbugging Markets

As we’ve previously seen many of the strange anomalies that affect investors have a nasty habit of disappearing, just as soon as people recognise that they exist. This wantonly random behaviour gives fuel to the last remaining adherents of the efficient markets hypothesis who can point out that despite the best attempts of behavioural financiers the evidence keeps on vanishing.

Despite the mysterious case of the missing anomalies there’s one that resolutely refuses to go away, squatting in the middle of the markets like a recalcitrant and extremely ugly toad. Rather ungraciously stocks continue to bounce around like a jitterbugger on speed. Regardless of everything else it’s volatility, the last anomaly, that keeps on giving. And then taking away. And then giving back again.

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Pricing Anomalies: Now You See Me, Now You Don’t

Imaginary Beasties

Down the years researchers have identified a whole host of pricing anomalies that offer strategies to outperform markets. Unfortunately as soon as anyone starts to exploit them these little beasts disappear like a bunny in a magician’s hat, leading everyone to wonder whether they ever existed at all.

The use of backtesting to identify such models which are then presented to the world as methods for getting rich – or at least ways of avoiding getting poor – shows, quite clearly, that the anomalies did exist at some point. So it appears we have the financial equivalent of the conjuror’s trick: now you see me, now you don’t.

Bad Models or …

There are two reasonable explanations of what might be going on. The first, roughly, is that the pricing anomaly really never existed in the first place and was the figment of fevered financial researchers’ imaginations. The second, even more roughly, is that as soon as the effect is identified then the market moves to eliminate the inefficiency: which is, after all, what you’d expect of an even vaguely efficient market.

The possibility that some of these effects never existed at all is a serious one. To identify the anomaly in the first place you have to have something to baseline it against. Given that all of the models of markets we’ve seen so far are seriously deficient at the extremes (see The Death of homo economicus, Holes in Black Scholes, etc, etc) there’s every reason to wonder if these apparent pricing inefficiencies are simply errors resulting from the modelling. After all, most market models are built around assumptions of efficiency and even if these are only roughly right the existence of clear inefficiencies would be odd.

Of course, given that all anomalies are identified through backtesting the possibility is open that the effect was simply a statistical blip. Take other data sets from other eras or other markets or an alternative universe and it may disappear. This is almost certainly what’s happening some of the time – but not all of it.

Loose Market Efficiency?

Still, if the pricing anomaly exists but hasn’t been recognised then there’s no especial reason for the markets to arbitrage it away. The fact that the effects disappear after they become widely known would suggest that markets are loosely efficient – they don’t necessarily act of their own accord to remove inconsistencies but will, if pushed and prodded towards the problem, do the right thing like a child eating its vegetables under duress and the promise of a highly calorific dessert, a new bike and the latest computer console. Slowly and painfully.

If you follow this logic through, even roughly, it would suggest that any pricing anomaly which becomes well known will disappear – even ones that are clearly based on human behavioural weaknesses. After all, in an age where mass computing power is available to the financial institutions that dominate our markets and Harry Potter lookalikes with whizzy computer models can swiftly magic up a program to exploit any identifiable discrepancy we should be moving towards greater market efficiency.

Instead of which, of course, we’re not. Which is good because otherwise I’d have nothing to write about.

And the Losers are …

As G. William Schwert points out, amongst the effects which were once bang-on winners but are now vanishingly irrelevant are the size effect, the value effect, the weekend effect and the dividend yield effect. The latter’s particularly interesting since an investment strategy based on predicting stock returns from historical dividend yield data was pretty successful up until the 1990’s when it failed spectacularly. Historically robust models can do you extreme damage if you trust in them too much: can anyone remember when bonds had never yielded more than equities? Nah, you’re all too young.

The value effect, where companies with low P/E ratios compared to the market earn excess returns, was identified back in the early 1980’s. Similar ‘value’ effects accruing to companies with high dividend yields or with assets in excess of their market capitalisations were also identified. However, when French and Fama modified the Capital Asset Pricing Model (CAPM) to take account of risk associated with company size and discounts to net asset value they discovered that the anomaly vanished.

Brilliantly the French and Fama three factor model rests not on the exploitation of reliable underlying market inefficiencies but on the fact that most of the market participants insist on using models that are demonstrably wrong. Here lies a delicious irony – it’s the activities of the boy wizards and their efficient market models that create the inefficiencies that allow others to make excess returns. They’re probably too busy fiddling with their broomsticks to take notice.

Heroic Smaller Investors

It really isn’t very hard to see why anomalies disappear once people start looking at them closely. What’s more interesting is why some anomalies don’t go all shy and retiring. The momentum effect, where stocks that have done well continue to do so and stocks that are lousy dogs keep on barking appears to be robust over all timescales and isn’t explicable by any modification of the current models. It’s also a possible explanation for the heroic underperformance of behaviourally challenged small investors who are apt to sell winners, which keep on winning, and keep losers, which keep on losing, in an attempt to continue to fund the securities industries’ enormous costs.

This underperformance is itself an anomaly, although one it’s difficult to exploit. Outside of the fat tails of market manic-depression one would generally expect even private investors to at least achieve market average returns. After all, efficient markets work both ways – it may be difficult to outperform but it should equally be hard to underperform. For their truly legendary efforts to disprove the Efficient Market Hypothesis smaller investors should be applauded, even if we simultaneously have serious doubts about their sanity.

An Exploitable Anomaly

It’s not just private investors that demonstrate such market beating, in a negative sense, abilities. Fund managers should, all things being equal, underperform the market to the extent of their fees. By and large this is true, low cost index funds included, but there are a few outstanding active managers who demonstrate the “cold hands effect” and produce underperformance of a magnitude that simply isn’t explicable by chance. As Hendricks, Patel and Zeckhauser put it:

“The relative performance of no-load, growth-oriented mutual funds persists in the near term, with the strongest evidence for a one-year evaluation horizon. Portfolios of recent poor performers do significantly worse than standard benchmarks; those of recent top performers do better, though not significantly so.”

So there you have it, finally: a truly exploitable anomaly. Find the very worst performing fund managers and do the exact opposite. Otherwise work hard on your real job, invest regularly in index trackers across a number of asset classes and expect to make no more than 8% per annum on a compounded basis. If you do the sums and don’t like the outcome then work harder and invest more, don’t count on higher investment returns – especially if your alternative is to bet on a backtested anomaly. After all, you never know when the darned thing will disappear in a puff of smoke.


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