For some time now I have been intrigued by the research on the so-called low volatility anomaly. So much so that I devoted a section to it in my book Abnormal Returns: Winning Strategies from the Frontlines of the Investment Blogosphere. The low volatility anomaly research shows that in contrast to established academic research stocks with lower volatility (or beta) actually outperform higher volatility. The findings are even more striking when you look at them in some sort of risk-return context.

Since finishing the book more research has come out on the topic. A couple of weeks ago Nardin Baker of Guggenheim Partners Asset Management, LLC  and Robert Haugen of Haugen Custom Financial Solutions and lowvolatilitystocks.com published a paper “Low Risk Stocks Outperform Within All Observable Markets in the World” at SSRN. The paper is accessible to non-academics and quants and provides some explanation on why these findings make sense in light of the agency issues with markets dominated by money managers.

Nardin Baker, co-author this paper, kindly agreed to answer some questions via e-mail about their paper and the practical implications of these findings for investors. The Q&A stands on its own, but I would recommend readers first check out Baker’s paper. You can read the first part our discussion below:

Abnormal Returns:  In the paper you use volatility to sort companies. Is this the best way to construct low volatility portfolios? Or should investors go through the extra effort to create minimum variance portfolios? Or as Eric Falkenstein notes that all of these methods, including low beta, all get you to pretty much the same place.

Nardin Baker: Low volatility stocks have outperformed consistently through time and across the world.  This leads to the question of how to best take advantage of the effect. While beta and other measures of volatility generally work well for sorting stocks based on risk, simple sorting is not a good way to take full advantage of the performance effect. In my opinion, portfolios that are constructed in an optimal way to reduce volatility while providing diversification and liquidity are more likely to perform well in the future.

The objective of producing the highest return for risk – maximizing the Sharpe ratio –  is largely determined by minimizing risk.  Minimizing risk is best controlled through portfolio optimization while paying attention to sector weights, individual stock weights, and liquidity.

Abnormal Returns: Low volatility has gotten a fair amount research, press and even the introduction of low volatility ETFs. Why is this anomaly likely to be more durable than others?

Nardin Baker: This is a very intriguing question whose answer has its roots in why low volatility stocks have outperformed in the past. Essentially, the difference between high and low volatility stocks is their excitement factor. High volatility stocks are exciting and in demand. Investors, including institutional fund managers, tend to invest in exciting stocks in an attempt to outperform. So, high risk stocks have underperformed in the past because of these behavioral and agency problems.

We believe the low volatility anomaly will persist because investors and fund managers will only modify their behavior slowly, if at all. Here is an interesting point – as investors gradually start to invest in low volatility stocks, the performance premium will increase. The outperformance of low volatility stocks is likely to be higher in the future if more investors are attracted to low volatility strategies. Unlike other anomalies, the low volatility effect will not be reduced in the near future, but is more likely to expand. In the extreme, once all investors have adapted to the low volatility effect, low risk stocks will be priced to generate the same Sharpe ratio as high risk stocks.

Abnormal Returns: The low volatility effect has some profound implications for corporate finance as well. Since Facebook is much in the news, does the low volatility effect help explain the underperformance of IPOs?

Nardin Baker: Excitement is core to the investment results generated by IPO’s. Generally, these securities are presented as attractive opportunities through road shows and other publicity.  Normally, these stocks are more volatile than average.  Although some IPO’s go on to perform well, on average the excitement factor of IPO’s leaves these issues priced too richly, leading to disappointing future returns.  Corporate finance is driven by the principle of efficient allocation of capital. But high risk IPOs that are overpriced can lead to sub-par investing.

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Thanks for Nardin for participating. Stay tuned for the second part of our discussion tomorrow.

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