As investment professionals, we were taught wrong. We were taught capital asset pricing model (CAPM) and efficient market hypothesis (EMH), which are overly simplistic. And contrary to what we were taught, low-volatility stock portfolios consistently outperform. This was the bold assertion made by Nardin Baker, CFA, chief investment strategist at Guggenheim Partners, who spoke to a hall full of investment professionals at the CFA UK Annual Conference 2013.
Referring to “Low Risk Stocks Outperform within All Observable Markets of the World,” a research paper he coauthored with Robert A. Haugen, Baker added that not only do these low-volatility stock portfolios outperform, but they also outperform in all equity markets of the world across time. Baker and Haugen’s study extends from 1990 to 2011 and covers stocks in 21 developed markets and 12 emerging markets.
To critics who may be eager to point out the usual problems with the research methodology, such as survivorship bias, nonrepresentative samples, and replication issues, the paper offers an early clarification: “Our procedure is intentionally simple, transparent and easily replicable. Our samples include non-survivors. Our database includes 99.5% of the capitalization in each country.”
The methodology used by Baker and Haugen is indeed simple to understand. They ranked the stocks in terms of volatility as measured by standard deviation and compared the returns for each month. As their paper says, “Beginning with the first month of 1990, we compute the volatility of total return for each company in each country over the previous 24 months. Stocks in each country are ranked by volatility and formed into deciles, quintiles, and halves. We then observe the total return for each decile in the first month of January. Next we re-rank stocks and observe the returns for February. Finally, we continue the process for each of the 264 months of the total period.”
Baker went on to claim that these low-volatility stocks don’t just outperform, they outperform by a wide margin, which becomes even wider when risk-adjusted returns are used. Terming it “the biggest market inefficiency” and “a huge opportunity,” Baker said that he has never seen any other strategy that is able to consistently perform at such a high level of return.
But why does “the biggest market efficiency” persist? Baker offered explanations relating to the principal–agent problem and behavioral biases:
- Investment managers are the agents of investors, and for a manager paid a base salary and a performance bonus, the expected value of compensation is higher with a more volatile portfolio.
- Security analysts have to compete within their firms and make a compelling case for the stocks they cover, so they opt for noteworthy stocks about which there is greater information flow, which happen to be high-volatility stocks.
- There are too few short positions in the market. Less than 2% of the value of the S&P 500 is held short. The high-volatility stocks are not being pounded down the way they should be.
- There is competition for higher return for capital. A high-growth company with a volatile stock could grow earnings at 25% but may only be able to grow earnings at 20% as other companies jump in. Unlike the growth of more volatile companies, those growing slower have lower volatility and less competition.
Baker said that investment strategies based on low-volatility stocks are not new; the first portfolio was created in 1988. According to Baker, low-volatility investment strategies did not take off back then because they were antithetical to financial theory, there was not enough competition among investment managers, and the market was rising. Investors were not sufficiently interested in low volatility. Baker thinks that as more and more investors buy low-volatility stocks, eventually their prices will rise and the prices of high-volatility stocks will fall. But at present, we are at the beginning of that process, and he is observing more inflows in low-volatility strategies than before.
Baker has faith in the outperformance of low-volatility stocks, even if it directly conflicts with what is suggested by CAPM and market efficiency. If something should give way, Baker thinks it should be the finance textbook. “There is no model that explains the real world,” he said.
The same sentiment is expressed in the conclusion of the paper: “It is now clear to a greater and greater number of researchers and practitioners that inside all of the stock (and even some bond) markets of the world, the reward for bearing risk is negative. Greater risk, greater reward is a basic tenant of finance; thus its invalidation carries critical implications for the theories underlying investment and corporate finance. In our view, existing textbooks on both subjects are dramatically wrong and need to be rewritten.”
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