Dumb Alpha: Getting Rich Slowly
“In Italy, for 30 years under the Borgias, they had warfare, terror, murder, and bloodshed, but they produced Michelangelo, Leonardo da Vinci. and the Renaissance. In Switzerland, they had brotherly love. They had 500 years of democracy and peace — and what did that produce? The cuckoo clock.” — Orson Welles as Harry Lime, The Third Man
As a German, I will ignore for the moment that the cuckoo clock was most likely not invented in Switzerland but in Germany. Instead, let me focus on the core message of this famous quote.
It conveys the common belief that great things come from instability, while stable, boring circumstances lead to stable, boring outcomes. Modern portfolio theory (MPT) also theorizes that instability breeds higher returns as, for instance, when the capital asset pricing model (CAPM) predicts that stocks with higher systematic risk (i.e., higher beta) should have higher returns.
Unfortunately, the first empirical tests conducted by Eugene Fama and James MacBeth demonstrated that CAPM predictions are not valid in real life.
The CAPM has been beaten and shamed for its empirical shortcomings from all sides, so I do not want to expand on the criticism here. Instead, I refer interested readers to James Montier’s well-thought and entertaining critique of CAPM in which he announces the model to be “Completely Redundant Asset Pricing” (CRAP).
I am not convinced that the CAPM is completely redundant. After all, it allowed us to identify several interesting “anomalies” that can be exploited by practitioners. In 1992, Fama and Kenneth French published their seminal paper introducing the three factors of market beta, size, and value. Over time, a momentum factor, investment factor, and profitability factor were included to explain the cross section of stock returns. But one conundrum always persisted: The risk premium on market beta was indistinguishable from zero. Whether you invest in high-risk or low-risk stocks, the returns remain the same.
David Blitz and his colleagues from the Dutch asset manager Robeco outlined this low volatility anomaly in a series of research papers, one of which indicated that investing in stocks with the lowest volatility within a given market tends to create significant outperformance over the market. And neither the value, the momentum, nor the size effect can explain any of this “dumb alpha.” There is even some indication that this low-volatility effect dominates the beta factor in real investments. So, instead of creating complex multilinear factor regressions, investors can outperform the market simply by selecting the stocks with the smoothest return profile — good, old, boring stocks that show no drama and a lot of stability.
So, if there is no extra risk premium attainable by investing in high-beta or high-volatility stocks, is there another advantage for long-term investors? Readers should remember the difference between arithmetic and geometric (or compound) returns. I apologize if I trigger traumatic memories of CFA exams here, but the relationship between the two is: geometric return = arithmetic return – 0.5 * variance.
Thus, if volatility (or variance) declines, geometric returns increase for a given level of arithmetic return. In practice, this implies that if investments can achieve a certain level of return, then one should choose the investments with the lower volatility in order to achieve a higher level of wealth over an extended period of time.
As I often ask my clients, “What is wrong with getting rich slowly?”
For more from Joachim Klement, CFA, don’t miss Risk Profiling and Tolerance: Insights for the Private Wealth Manager, from the CFA Institute Research Foundation, and sign up for his regular commentary at Klement on Investing.
If you liked this post, don’t forget to subscribe to the Enterprising Investor.
All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Image credit: ©iStockphoto.com/CSA-Archive
3 thoughts on “Dumb Alpha: Getting Rich Slowly”
Nothing wrong with getting rich slowly but at current levels low-volatility stocks are very rich. The best you can probably hope for is static prices as earnings very slowly grow into inflated multiples. Not much true value in this area these days in my opinion.
I would highly recommend you seek out Rob Arnott’s recent writing about “low vol” factor investing. One thing is almost for certain, if everyone is doing it, then it is probably not good for your financial health.
I have read Rob’s piece and agree with all the concerns about high valuations in low vol stocks (particularly when it comes to utilities, staples and health care). So long-term expected returns should be quite a bit lower than the historic track record.
But: First of all I wonder why low vol stocks have become so expensive? In my view they have become a stand-in for “bond proxies” in times of extremely low bond yields. While the situation might slowly change in the US at least here in Europe we are very far away from rising interest rates and as a result, the driver of demand for low vol bond proxy stocks should remain in place for quite some time.
Second, the question is not whether returns will be lower in the future than in the past but whether low vol stocks will outperform the overall market in the future. High valuations will depress low vol return and also partially depress overall market returns. Yet, if the research quoted above is correct and the low vol effect is independent of the value premium then it does not seem clear to me ex ante that high valuations will overwhelm the effect of low vol stocks outperforming the overall market. I think research still needs to be done to investigate what happens when different factors point in different directions.