7 Steps to Successful Low Volatility Investing – Part 2
The reality is much of the institutional money in the market (mutual funds, pension funds, insurance companies, etc.) cannot use leverage. In fact, many are required to have some of their assets in cash, such as mutual funds that may need to meet daily redemptions and insurance companies that may need to pay claims.
The need to hold cash makes it difficult for mutual funds to beat their benchmark – they can’t just buy the market. This creates an incentive for them to over-weight high beta (high volatility) stocks in order to avoid lagging the benchmark in a bull market. Their hope is that these high beta stocks will rise the most in a bullish environment making up for their cash holdings and potentially allowing them to beat their benchmark.
Thus the prices of high volatility stocks are pushed up too high relative to their true value (i.e. they become over-bought). Eric Falkenstein, author of Finding Alpha, calls this the “hope premium” for high beta stocks.5 At the same time, there is less institutional money moving into low volatility stocks which become undervalued (i.e. over-sold).
What about the Efficient Market? Won’t the institutional money eliminate the arbitrage opportunity before the average investor can capitalize?
Again the theory doesn’t match up with the real world. Roughly one-quarter of the market is mutual funds. They cannot short sell equities to take advantage of the opportunity. The other two largest sources of institutional “smart money” are insurance companies and pension funds. Likewise, they too are often restricted from shorting or using leverage.
Thus the arbitrage opportunity is left primarily to hedge funds. Most hedge funds do not have the same restrictions on leverage or short selling. So are hedge funds going to create efficiency in the roughly $15T U.S. market?
Not likely. The total U.S. hedge fund assets are only about $1.8T in 2012 (roughly 12% of the market). And only a third of those funds focus on long/short equity opportunities.7 This helps to explain how the low volatility investing can continue to work 40 years after it was first reported.
There’s an old saying to the effect of individual investors and traders are best advised to avoid strategies that try to pick up nickels in front of steamrollers. In other words, don’t try to beat the big institutions at their game. As it turns out, betting against beta is a game that is difficult for much of the smart money to play.
Source: Eric Falkenstein, PRMIA Seminar, Aug 2010, “The Risk Premium is Practically Zero.” Past performance is no guarantee of future results.
So the second step of the Low Volatility Investing Method is to buy stocks with low volatility and to sell short stocks with high volatility as suggested in the paper “Betting Against Beta.”
Practically, there are 4 basic ways to implement this strategy in your trading and investing. You can consider either relative volatility or absolute volatility.
(1) Select a stock universe that has low volatility relative to another stock universes (i.e. choose the S&P 500 over the Russell 2000).
(2) Sort your universe of stocks by volatility (either beta or historical volatility). This is also a relative volatility measure and is the methodology used in the paper “Betting Against Beta” and most other studies done on the low volatility anomaly.
(3) Filter your universe of stocks by an absolute measure of volatility such as beta, historical volatility, or ADX. In this case you might only consider buying stocks with an ADX less than 20 or selling short stocks with an ADX greater than 40.
(4) Rank your potential investments by relative volatility and fill a predetermined number of positions according to the ranking. For instance, if 20 stocks meet your buy criteria on a given day, but your strategy has 10 positions in the portfolio (i.e. each stock is 10% of your equity), then you would choose the 10 stocks with the lowest beta (or some other volatility measure).
We use both relative and absolute volatility measures in the strategies in our portfolios.
In the next article in this series we’ll discuss steps 3 and 4. You’ll learn how to diversify your portfolio by using strategies with different hold periods and how to use momentum to your advantage.
1 Low Risk Stocks Outperform within All Observable Markets of the World (Baker and Haugen, 2012) and lowvolatilitystocks.com. Study of 2997 U.S stocks and 9494 stocks from 21 developed countries; standard deviation over previous 24 months was used as the measure of risk.
2 2011 Financial Analyst Journal, January/February issue, volume 67, no.1, www.cfapubs.org
3 “The Capitalism Distribution” Blackstar Funds report.
4 “Betting Against Beta” (A. Frazzini and L. Pedersen, 2011).
5 Finding Alpha: The Search for Alpha When Risk and Return Break Down (Erik Falkenstein, 2009).
6 The Missing Risk Premium: Why Low Volatility Investing Works (Erik Falkenstein, 2012).
7 Credit Suisse 2012 Hedge Fund Market Review.