Contrary to popular belief, riskier investments do not necessarily translate into higher returns.
Rather paradoxically, we have seen that more volatile stocks tend to yield lower risk-adjusted returns in the long run, while their less volatile peers typically tend to deliver higher risk-adjusted long-term performance.
The capital asset pricing model (CAPM) dates back to 1964 and has long been the centerpiece used to explain the relationship between risk and return. According to the theory, higher risk should lead to higher returns. Empirical findings, however, contradict this notion. Figure 1 depicts the risk-return profile of ten portfolios sorted on the volatility of historical returns. This clearly shows that the equity market has generally not rewarded investors for taking on more (volatility) risk.
Figure 1 | Long-term risk-return profile of ten volatility-sorted portfolios
Source: Robeco, CRSP. Figure shows average, annualized returns and volatilities of 10 portfolios sorted on past 36-month return volatility. The investment universe covers all common stocks traded on NYSE, AMEX and NASDAQ exchanges with valid market capitalization and return data from 1926 till 2020. Portfolios are equal weighted and portfolio returns are from January 1929 to December 2020.
Low volatility stocks are typically found in defensive sectors and have more predictable cash flows, leading them to exhibit lower valuation uncertainty. Thus, they portray bond-like characteristics, while investors are also likely to use them as replacements for bonds given that they typically pay out dividends. Despite these features, Robeco research concluded that interest rate risk does not account for the long-term added value from low volatility strategies.
Investor behaviour drives Low Volatility premium
Behavioural biases and constraints offer more convincing reasons for why low volatility stocks have the potential to generate higher risk-adjusted returns than their high volatility counterparts. But in contrast to other factor premiums that are driven by irrational investor behaviour, the low volatility anomaly is premised on ‘rational' investor behaviour.
Within the investment industry, relative returns often supersede absolute returns as a yardstick for performance or manager aptitude. Low volatility investing can therefore be unpopular due to how markedly different low volatility portfolios can look when compared to benchmarks. This results in higher tracking errors (relative risk) that are not palatable for some investors, especially when short-term underperformance in up markets is a possibility.1 Thus, the desire to keep up with the markets against which portfolios are measured incentivises investments in high volatility stocks.
The focus on relative performance gives rise to so-called agency issues according to research.2 Investment professionals usually have option-like incentive contracts. They typically seek to maximize the value of these by targeting high portfolio returns, which can cause them to be more attracted to higher-risk stocks.
1 Falkenstein, E., June 2009, "Risk and return in general: theory and evidence", working paper.
2 Blitz, D., Falkenstein, E., and Van Vliet, P., April 2014, "Explanations for the volatility effect: an overview based on the CAPM assumptions", Journal of Portfolio Management.
This post is funded by Robeco
