(Pictured: Feifei Li)
The rise in popularity of smart-beta since the global financial crisis has prompted a resurgence in debate about the various factors which quant managers use in devising their strategies. More importantly, whether the characters these factors exhibit are likely to persist.
The low-volatility premium is particularly topical and is winning hearts and minds, while the small-cap premium appears to have been largely debunked. Small caps may outperform, but not on a risk-adjusted basis.
According to Research Affiliates of Newport Beach, California, which developed the RAFI range of index funds (Research Affiliates Fundamental Index), low volatility should not be called “an anomaly” because this implies “the hope for an explanation that is consistent with the standard model”.
RAFI has a dedicated low-vol fund but also uses, like a lot of other quant managers, the low-vol effect in several broader index strategies. A recent RAFI paper, written by Feifei Li, spells out the reasons which low-vol should be considered a premium and is likely to persist, but she concludes that there may be periods where it does not appear to.
The low-vol effect dates back to the late 1960s when it was observed by academics Robert A Haugen and A James Heins. It has been well studied since and unless contrarian investing paradoxically becomes the norm, “there is good reason to believe that it won’t go away any time soon”, Li says. But there’s always a worry about the weight of money, which has ruined many a good strategy before.
Low-vol stocks tend to trade at a discount to higher-volatility stocks but have produced excess returns – in much the same way that value stocks have – over many, but not all, time periods and in most markets.
In her paper, Li argues that behavioral factors offer the explanation. It is a fundamental belief in finance that risker assets should deliver higher returns, but here is the claim that less risky (defined by less volatility) assets do. So, there is the first behavioral bias: people don’t like, on average, to deviate too far from existing norms. This is supported by evidence that people in general prefer positively skewed lottery-like payoffs. The more common this pattern the more likely it is to produce the low-vol effect by itself.
But there are other factors in play. Li says that there is also evidence that constraints on the use of leverage, or an aversion to it, by many investors will also drive them towards higher volatility stocks and away from low-vol stocks.
And then there are agency issues. Because fund managers are generally judged against cap-weighted indices they are implicitly discouraged from over-weighting low-vol stocks. Li, of course, is talking the book of her employer, since RAFI came about because of perceived flaws in cap-weighted indices as investment strategies. Nevertheless, her arguments are plausible.
Clients, such as super funds, who place a tolerance range around tracking error facilitate monitoring asset class risk exposures but also, however, promote “closet index hugging”. Managers who underperform a cap-weighted index for, say, three years will tend to be “de-selected”.
“In consequence, managers face what David Tuckett and Richard J. Taffler call ‘real risk’,” she says. “This is the risk of losing clients, bonuses and ultimately their job due to underperformance. This is a powerful incentive to cling to the cap-weighted index.”
While she concludes that over the long term it is reasonable to expect low-vol investing to persist in producing excess returns, Li says there will most likely be periods when investors’ demand for low-vol stocks will drive prices up and reduce the return premium to an unattractive level.
View the full paper.