The Low-Volatility Factor and Occam’s Razor

Pim van Vliet, PhD, is the creator of High Returns from Low Risk: A Remarkable Stock Market Paradox, with Jan de Koning.

The low-volatility premium could be the most compelling anomaly in financial markets: Less risky securities outperform their riskier counterparts over the long run.

Empirical exams of the capital asset pricing mannequin (CAPM) first documented this counterintuitive phenomenon greater than a half century in the past. It emerged not in a seek for alpha however fairly as an unwelcome actuality, an unintended consequence of concept testing, and remains poorly understood to this present day.

This makes the defensive low-volatility issue distinctive and units it other than different elements.

Because the low volatility issue defies a risk-based explanation, teachers who imagine in environment friendly markets have hassle accepting it. Certainly, Eugene Fama and Kenneth French left low volatility out of their three-factor and five-factor models. 

Practitioners, in contrast, typically battle to capitalize on the issue due to the excessive threat related to it relative to its benchmarks and due to leverage constraints and potential profession dangers.

Such complexities and hurdles make low volatility a particular animal inside the increasing “issue zoo.”

But the low-volatility issue is each resilient and sturdy.

Right here, by making use of the precept that the best rationalization is normally probably the most correct — Occam’s razor — we make the case for low volatility. The graphic under exhibits how low volatility interacts with different elements. Even after seven cuts or slices, the issue nonetheless performs. If it retains its alpha after so many slices, its simplicity should be key to its significance.

The Beginning Level: CAPM

Utilizing US market knowledge from July 1940 to December 2023, we measure the volatility factor very like a Fama and French model issue, by taking an extended place on low-volatility shares and a brief one on their high-volatility counterparts. Over this era, the low volatility premium (VOL) equals 6.4% with a beta that by building could be very near zero. The CAPM alpha is 6.3% every year with a t-stat of 5.3, far above the essential ranges Campbell Harvey recommended to minimize the risk of finding “fake factors.”

Low-Volatility Premium (VOL) Managed for Different Elements, July 1940 to December 2023

Sources: The Kenneth R. French Data Library and Paradox Investing

The First Slice, 2FM (Charges): Two Elements, Equities and Bonds

When the CAPM was unveiled, Richard Roll’s critique was that bonds and other assets should be included in the market portfolio. Since low-volatility shares resemble bond-like shares, this greater rate-sensitivity may very well be an evidence. Nonetheless, a two-factor regression that features each equities and bonds lowers VOL’s alpha by solely 0.3%.

Second Slice, FF 3FM: Fama-French Three-Issue Mannequin

One rationalization of the low-volatility issue is that worth is usually defensive. Whereas the connection is time various, on common volatility masses positively on worth and negatively on dimension. The basic three-factor Fama–French regression, which incorporates each the worth and dimension elements, reduces VOL’s alpha by 1.1%.

Third Slice, 4FM (Inv): Three-Issue Mannequin Plus Funding

Fama and French augmented their three-factor mannequin with two extra elements — funding and profitability — in 2015. We discover the funding issue accounts for about 0.5% of VOL’s alpha. This makes intuitive sense since conservative, low-investment corporations are inclined to exhibit much less volatility. 

Fourth Slice, 4FM (Prof): Three-Issue Mannequin Plus Profitability

Of those two new elements, profitability has a a lot stronger relationship to volatility and accounts for 1.2% of VOL’s alpha. We discover that unprofitable corporations are usually very unstable at the same time as their worthwhile friends don’t at all times reveal the alternative. Thus, the short leg drives most of this result. 

Fifth Slice, FF 5FM: Fama-French 5-Issue Mannequin

Mixed, these 5 elements carry VOL’s alpha down by 0.9%. This means that funding and profitability are completely different dimensions of the standard issue that work together with worth and dimension. 

Sixth Slice, 6FM (Mother): 5-Issue Mannequin Plus Momentum

Probably the most dynamic issue, momentum, generates excessive gross returns however requires appreciable turnover, which erodes web returns. This is the reason Fama and French didn’t embody it of their five-factor mannequin. Once we add momentum, the VOL premium doesn’t rise or fall.

Seventh Slice, 7FM: The Kitchen Sink

In our remaining, all-inclusive “kitchen sink” regression, VOL’s alpha declines by 0.2% and remains to be standing at a statistically important 2.1%. 

All this demonstrates low volatility’s general robustness. The issue’s outperformance survives critiques from all completely different angles. By making use of Occam’s razor to the issue zoo and slicing low volatility each which method, the technique nonetheless stands out because the premier issue. If it takes 5 or 6 elements to elucidate it, low volatility might not be that dangerous in any case.

To take it one step additional, by integrating worth, high quality, and momentum right into a “Conservative Formula,” we create an enhanced low-volatility technique that beats VOL together with all the opposite elements. The next determine exhibits how the Conservative Minus Speculative (CMS) portfolio fares after every of our earlier cuts. The alpha begins at 13.3% and solely falls to eight.2% in any case seven slices.

Enhanced Volatility Premium (CMS) Managed for Different Elements, July 1940 to December 2023

Sources: The Kenneth R. French Data Library and Paradox Investing

Amid low demand for defensive investing through the latest tech-driven market rally, the case for low-volatility investing could also be stronger than ever. In a market that usually overlooks it and a world the place the apparent is usually overcrowded and overvalued, the low-volatility anomaly stands as a testomony to the facility of contrarian pondering.

Generally, the less-trodden path presents the higher journey. As we glance forward, the query stays: Will the market ultimately catch as much as this hidden gem, or will low volatility proceed to be the market’s best-kept secret?

For extra from Pim van Vliet, PhD, don’t miss High Returns from Low Risk: A Remarkable Stock Market Paradox, with Jan de Koning.

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All posts are the opinion of the creator. As such, they shouldn’t be construed as funding recommendation, nor do the opinions expressed essentially mirror the views of CFA Institute or the creator’s employer.

Picture credit score: ©Getty Pictures / Jordan Lye

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