It’s not breaking news that growth stocks have far outpaced those labeled or placed in the ‘value’ bucket. By definition the former should be growing, its share price increasing, at a faster pace than the latter. Value investors know they are going to need patience and time for others to discover and learn the true worth of the businesses they believe aren’t getting their due. Today’s investing advice explores the wisdom of this approach.
As it happens, the premium being paid for growth over value is now at the highest level since the late 2000 dot.com bubble.
And while we know one of the basic tenants of investing is that to achieve higher returns, one usually has to accept greater risk, ValueWalk has done a nice analysis showing how the equation also ties into respective volatility levels across various asset classes.
Here they present Deconstructing the Low Volatility/Low Beta Anomaly. It’s bit wonky, but worth the effort:
One of the big problems for the first formal asset pricing model developed by financial economists, the Capital Asset Pricing Model (CAPM), was that it predicts a positive relationship between risk and return. However, the historical evidence demonstrates that, while the slope of the security market line is generally positive (higher-beta stocks provide higher returns than low-beta stocks), it is flatter than the CAPM suggests.
Importantly, the quintile of stocks with the highest beta meaningfully underperform stocks in the lowest-beta quintile in both U.S. and international markets — the highest-beta stocks provide the lowest returns while experiencing much higher volatility. Over the last five decades, defensive stocks have delivered higher returns than the most aggressive stocks, and defensive strategies, at least those based on volatility, have delivered significant Fama-French three-factor (market beta, size, and value) alphas. This runs counter to economic theory, which predicts that higher expected risk is compensated with a higher expected return.
The low-volatility anomaly has been demonstrated to exist in equity markets around the globe. What’s interesting is that this finding is true not only for stocks, but for bonds as well. The academic research, combined with the 2008 bear market, has led to low-volatility strategies becoming the darling of investors.
For example, as of October 2017, there were seven ETFs with at least $1 billion in AUM:
- iShares MSCI USA Minimum Volatility Index Fund (USMV): $14.2 billion
- iShares MSCI EAFE Minimum Volatility Index Fund (EFAV): $7.6 billion
- PowerShares S&P 500 Low Volatility Portfolio (SPLV): $7.2 billion
- iShares MSCI Emerging Markets Minimum Volatility Index Fund (EEMV): $4.2 billion
- iShares MSCI All Country World Minimum Volatility Index Fund (ACWV): $3.5 billion
- PowerShares S&P MidCap Low Volatility Portfolio (XMLV): $1.2 billion
- PowerShares S&P Small Cap Low Volatility Portfolio (XSLV): $1.8 billion
There were 15 more with at least $100 million of AUM (source).
There are three main explanations offered for the low-volatility anomaly:
- Many investors are either constrained against the use of leverage or have an aversion to its use. Such investors who seek higher returns do so by investing in high-beta stocks, despite the fact that the evidence shows that they have delivered poor risk-adjusted returns. Limits to arbitrage and aversion to shorting, as well as the high cost of shorting such stocks, prevent arbitrageurs from correcting the pricing mistake.
- There are individual investors who have a “taste” for lottery-like investments. This leads them to “irrationally” invest in high-volatility stocks (which have lottery-like distributions) despite their poor returns. They pay a premium to gamble.
- Mutual fund managers who are judged against benchmarks have an incentive to own higher-beta stocks. In addition, managers’ bonuses are options on the performance of invested stocks, and thus more valuable for high-volatility stocks.