Volatility anomaly suggests slow and steady wins the race

From Asset Allocation / Equity 28 February 2012

William De Vijlder, BNP Paribas Investment Partners

By Elliot Smither

Low risk equities tend to outperform their racier counterparts over the long-term and provide portfolios with much less volatility, thanks to human behaviour

It was back in 1968 that Professor Bob Haugen, a leading proponent of quantitative investing and long-term believer in the inefficiencies of stockmarkets, discovered the ‘volatility anomaly’. This explains how low volatility stocks outperform high volatility stocks, due to behavioural factors which inflate the demand for high volatility equities and impact on their future returns. In the meantime, low volatility stocks continue to deliver both alpha and beta, and at much lower levels of risk.

BNP Paribas Investment Partners, which now employs Professor Haugen as one of their senior advisers, recently launched a white paper, Demystifying equity risk-based strategies. Simple alpha plus beta description, written by their Financial Engineering team and which focuses on the volatility anomaly. William De Vijlder, CIO Strategy and Partners at the French firm, explains how investors’ interest in low volatility stocks has increased following the difficult market environment they have had to contend with over the last few years.

“The reason we do all of this research and work is to make our clients think about how they want to have equity exposure in their portfolios, because there is a school of thought that says ‘I’ll just go for a cap-weighted index’.

“Once they buy into the idea that there are other indices that have very attractive characteristics in the longer run from a relative return perspective and so on, you can then zoom in and start working on really tailor-made solutions which can address the preferences that the client has, and also their constraints.”

The white paper examines a number of equity risk-based strategies such as minimum variance, maximum diversification and equal risk contribution and highlights how they have all managed to outperform the market-cap index over a medium to long-term period, while displaying lower volatility. Low risk stocks tend to have higher returns than would be expected from their level of risk, and this difference is alpha. This can be explained by the behaviour of fund managers. Active managers looking to outperform the index have no incentive to buy low risk equities and tend to look for the “story” stocks that would bring them high returns, but carry more risk. And there is no reason for this to change, says Gilles Guerin, chief executive officer at Theam, the BNP Paribas IP's specialist in index, active systematic, guaranteed and alternative investment. “The anomaly is there and we believe it is there to stay. There is a natural bias for it to stay.”

Low volatility strategies do, however, tend to lag the index in fast rising markets, explains Mr De Vjilder. While none of them are perfect and all tend to have in-built weaknesses – for example they tend to display high levels of tracking error that many institutional investors could be uncomfortable with – the structures behind them are certainly worth further consideration when designing client portfolios.

For example, the BNP Paribas Equity World Low Volatility fund, which has outperformed the benchmark by 8.35 per cent since inception, is being utilised as something of a showcase to gain the interest of clients who can then have solutions tailor-made to something suitable for their particular needs.

But could the volatility anomaly be put to use in other asset classes? Although BNP Paribas reports that an increasing number of European clients are asking the French firm to look at bond indices and possible ways of getting smart bond beta, there is an important distinction to be made, explains Mr De Vijlder.

“There is an anomaly in the equity markets, full stop. And that is as close as you can get to a free lunch. However, when you look at it from a bond perspective you can build tailor-made benchmarks, but in the longer-run you do not have that type of anomaly. Taking on credit risk is rewarded in the bond market.”