Deconstructing the Low-Volatility Anomaly

#6- Volatility Effect in Stocks – Long-Short Version
#7- Volatility Effect in Stocks – Long-Only Version

Authors: Stefano, Lamperiere, Bevaratos, Simon, Laloux, Potters, Bouchaud

Title: Deconstructing the Low-Vol Anomaly



We study several aspects of the so-called low-vol and low-beta anomalies, some already documented (such as the universality of the effect over different geographical zones), others hitherto not clearly discussed in the literature. Our most significant message is that the low-vol anomaly is the result of two independent effects. One is the striking negative correlation between past realized volatility and dividend yield. Second is the fact that ex-dividend returns themselves are weakly dependent on the volatility level, leading to better risk-adjusted returns for low-vol stocks. This effect is further amplified by compounding. We find that the low-vol strategy is not associated to short term reversals, nor does it qualify as a Risk-Premium strategy, since its overall skewness is slightly positive. For practical purposes, the strong dividend bias and the resulting correlation with other valuation metrics (such as Earnings to Price or Book to Price) does make the low-vol strategies to some extent redundant, at least for equities.

Notable quotations from the academic research paper:

"Our main results are as follows:

We do confirm once again the strength and persistence of the low-vol and low- beta effect on a pool of 9 different countries; in fact we find that the P&L of the two anomalies are very strongly correlated ( ≈ 0.9) suggesting that these two anomalies are in fact one and the same. However, since the market neutral low-vol/low-beta strategy has (by construction) a long dollar bias, it is sensitive to the financing rate.

We find that the low-vol anomaly has nothing to do with short-term (one month) stock reversal – at variance with some claims in the literature, as it entirely survives lagging the measure of past volatilities by one month or more. The low-vol effect is therefore a persistent, long-term effect.

We find that, as expected, low-vol (low- beta) portfolios have strong sector exposures. However, the performance of these strategies remains strong even when sector neutrality is strictly enforced. The low-vol effect is therefore not a sector effect.

We find that a large proportion of the low-vol performance is in fact eked out from dividends. This is our central result, that follows from the strong negative correlation between volatility and dividend yields which (oddly) does not seem to be clearly documented in the literature. However, the low-vol anomaly persists for ex-dividend returns which are found to be roughly independent of the volatility level. Therefore risk-adjusted exdividend returns are themselves higher for low-vol stocks, which is in itself an “anomaly”.

We find that the skewness of low-vol portfolios is small but systematically positive, suggesting that the low-vol excess returns cannot be identified with a hidden risk-premium.

The P&L of the low-vol strategy is ∼ −0.5 correlated with the Small-Minus-Big (Size) Fama-French factor, ∼ 0.2 correlated with the High-Minus-Low (Value) factor and ∼ 0.5 correlated with the Earning-to-Price factor, which is expected since earnings and dividends are themselves strongly correlated. Once these factors are controlled for, the residual performance of low-vol becomes insignificant. This result ties with Novy-Marx’s observations: profitability measures explain to a large degree the low-vol (low-beta ) effect.

We find that part of the low-vol effect can be explained by compounding, i.e. the mere fact that a stock having plummeted −20% must make +25% to recoup the losses. Although significant, this mechanism is only part of the story.

By analyzing the holding of mutual funds, we find that (at least in the U.S.) these mutual funds are indeed systematically over-exposed to high vol/small cap stocks and underexposed to low-vol/large cap stocks, in agreement with the leverage constraint and/or bonus incentives stories alluded to above. A similar observation was made in Ref. [13] concerning the behaviour of Japanese institutional investors.

Our overall conclusion is that, while the low-vol (/low-beta ) effect is indeed compelling in equity markets, it is not a real diversifier in a factor driven portfolio that already has exposure to Value type strategies, in particular Earning-to-
Price and Dividend-to-Price. Furthermore, the strong observed dividend bias makes us believe that the effect is probably not as convincing in other asset classes such as bonds."

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