Tag Archives: marketplace

The Low Volatility Anomaly: Leverage Aversion Hypothesis

This series digs deeper into the Low Volatility Anomaly, or why lower risk stocks have historically produced stronger risk-adjusted returns than higher risk stocks or the broader market. The CAPM links expected returns with an asset’s sensitivity to systematic risk, but the model assumptions are impractical. This article covers a deviation between model and market that may contribute to the outperformance of low volatility strategies. Given the long-run structural alpha generated by low volatility strategies, I am dedicating a more detailed discussion of the efficacy of this style of investing. In the first article in this series , I provided an introduction to the strategy with a simple example demonstrating a low volatility factor tilt (replicated through SPLV ) from the S&P 500 (NYSEARCA: SPY ) that has generated long-run alpha. In the second article in this series , I provided a theoretical underpinning for the presence and persistence of a Low Volatility Anomaly, and linked to articles depicting its success dating back to the 1930s. This article demonstrates that violations of the assumption of the Capital Asset Pricing Model (CAPM) lead to deviations between model and market that pervert the presumed relationship between risk and return. Empirical evidence, academic research and long time series studies across asset classes and geographies have shown that the actual relationship between risk and return is flatter than the model or market expectations suggests. The third article in this theory lays out a hypothesis for why low volatility strategies have produced higher risk-adjusted returns over time. Leverage Aversion Hypothesis The fallacy of the Capital Asset Pricing Model assumption that investors are able to borrow and lend at the risk-free rate might be the supposition that most perverts the model application from real world practice. Certainly not all investors are able to use leverage, and the cost and availability of leverage can deviate materially from any notion of a risk-free rate in times of stress. Intuitively, leverage-constrained or leverage-averse investors often choose to overweight riskier assets, increasing the price of risky assets and lowering expected return. If some market participants are overweight riskier assets characterized by lower expected returns, then they must be underweight lower risk assets which would be characterized by higher expected returns. In the CAPM model, rational market participants seeking to maximize their economic utility invest in the portfolio with the highest expected return per unit of risk, and lever or de-lever their portfolio to suit their own risk tolerance. In practice, however, many large institutional investors including most mutual funds and certain pension funds are constrained by the level of leverage that they can take. Furthermore, many individual investors lack the sophistication or access to attractively priced leverage. The growing increase in the assets under management of exchange traded fund products with embedded leverage could well signal small investor’s inability to access leverage directly on favorable terms. If market participants respond by being overweight riskier securities, then the relationship between risk and expected return is altered. Building on the long time series studies from Black and Haugen of the relative outperformance of lower volatility assets in the last article in this series, Frazzini and Pederson (2010) empirically demonstrated the alpha-generative nature of low beta assets across twenty international equity markets, Treasury bonds, corporate bonds, and futures. The duo also introduced a “Betting Against Beta” factor that gave the paper its name. The factor is effectively a zero beta portfolio that is long leveraged low-beta assets and short high-beta assets to produce statistically significant risk-adjusted across many markets, geographies, and time intervals. This study also demonstrated that the return of the BAB factor is sensitive to funding constraints as one would expected in a trade involving leverage. The persistence of an alpha-generative strategy involving leverage applied to low volatility assets, whose excess return is in part a function of the funding environment, supports the Leverage Aversion Hypothesis as an explanation for the Low Volatility Anomaly. In the next section of this series, we will tackle how the delegated agency model typical of investment management may also contribute to the outperformance of Low Volatility strategies. Disclaimer My articles may contain statements and projections that are forward-looking in nature, and therefore, inherently subject to numerous risks, uncertainties and assumptions. While my articles focus on generating long-term risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance, and investment horizon. Disclosure: I am/we are long SPLV, SPY. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

5 Second-Half Tips For Investors

Rising Rates Aren’t the Only Market-Mover Much of the market’s focus so far in 2015 has been on when the US Federal Reserve (Fed) will raise rates. With the Fed promising to be “data-driven,” each economic release has received more scrutiny than usual. But the decision on rates is not the only driver of markets. Increasingly, events and data outside the US are having an impact on markets here at home, adding to the range of factors that affect investors: 5 Tips for Investors 1. Ensure adequate exposure to risk assets. Many investors with longer time horizons are in jeopardy of being unable to fund their goals because their allocations are over-exposed to cash and core bonds. For long-term goals like retirement or a college education, portfolios need exposure to asset classes that have the potential to deliver growth – which means investors need adequate exposure to stocks. 2. Watch out for interest-rate complacency. At some point, the Fed will begin raising interest rates, and we don’t believe most market participants are prepared for the hike. Equity investors should anticipate some negative short-term reactions in the stock market, but should also keep in mind that equities have historically sustained several rate rises before declining. What’s more, given how low short-term rates currently are, higher rates would be unlikely to constrain economic output and activity which means that any equity-market selloff should be limited. The greater risk of complacency may lie with owners of US treasuries and other core bonds who are anticipating continued lower rates, those investors may be unpleasantly surprised. 3. Be risk-aware. While many investors worry about more obvious risks, such as tail risk (the risk of an asset or portfolio moving more than three standard deviations away from its current price), they may be less aware of other dangerous threats, such as liquidity risk. For example, in a recent Allianz Global Investors survey on risk, we found that 95% of institutional investors believe tail risks pose a medium, high or very high risk of likelihood over the next 12 months, but 40% view liquidity risk as little or no threat. And even though investors worry about tail risk, far fewer believe they are adequately equipped to protect against it: just 27% use strategies that hedge against it. It’s critical for investors to be well-informed about all the risks facing their portfolio and the risk-management tools they have at their disposal. 4. Protect against volatility. We expect increased volatility in both stock and bond markets. This may mean investors should reduce their exposure to fixed income. However, investors shouldn’t abandon stocks because of higher volatility; instead, they should manage that volatility wherever possible. We recommend the use of options strategies and other sophisticated tools, in addition to broad portfolio diversification and exposure to dividend-paying stocks, which have historically offered lower volatility than the overall stock market. 5. Use active management. In this unique and unpredictable market environment, we expect correlations among stocks and among asset classes to fall, creating a more differentiated market environment in which active managers can outperform. In addition, we expect rotations in leadership among different asset classes. Investors might want to consider using an actively managed multi-asset investment that offers broad exposure and can adjust allocations to take advantage of opportunities (including low valuations) and manage risks (including rising rates and geopolitical crises). Strategies like these can also help investors offset behavioral biases and self-inflicted psychological obstacles by providing one professionally managed investment that they can “set and forget.” The Bottom Line In the second half of 2015, investors need to recognize that downside risk has increased for both stocks and bonds. However, if they have long time horizons – and if they use risk-management tools in a well-diversified, actively managed portfolio with adequate exposure to risk assets – then they should be in a much better position to meet their long-term goals.

The Problem With Leverage In A Portfolio

Barry Ritholtz has a new article on Bloomberg discussing San Diego County’s firing of a risk parity firm that used to manage part of its pension. Risk parity strategies often engage in using leverage. Cliff Asness, who runs AQR, a firm implementing risk parity approaches (among others), hated Barry’s piece and called it “facile” “innuendo”. He then referred to a piece explaining why he likes leverage in a portfolio at times. So, who’s right? Leverage is a bit like steroids. Steroids are neither good nor bad. They tend to magnify the effect of something and that can be good or bad depending on how it’s used. If you use steroids in specific targeted ways they can be an effective medical treatment. Likewise, if you abuse them they can be a destructive and unnecessary supplement.¹ Leverage is essentially the same thing. It will magnify the effect of a portfolio’s outcomes. There are very reckless ways to do this and very safe ways to use leverage. But one thing is almost always undeniable – leverage will cost you. And that’s the kicker. Borrowing money you don’t have is essentially a form of renting. And renters charge fees. The cost of leverage in a portfolio typically depends on the fee that brokers charge. This is usually a spread over LIBOR. This allows clients to fund their long positions and the broker pays some spread below LIBOR for cash deposited by the clients as collateral for short positions. The cost of the leverage will vary depending on who the borrower is.² The inherent difficulty in using leverage is that the fund manager is essentially passing on another cost to the end investor. That is, leverage reduces the real, real return of a portfolio by the cost of the leverage. In the aggregate we know that all managers are generating the market return minus their costs (taxes, fees, etc.) so if everyone started using leverage then our returns would be reduced by the cost of the leverage. And that’s the difficulty of using leverage in a portfolio. I like the concept of Risk Parity, but it’s hard to justify owning a lot of such a strategy simply because it’s an inherently expensive strategy to manage. And in a world that is likely to be a low return world that is potentially just adding another hurdle we don’t need. ¹ – I am not a doctor and I don’t even play one on TV. ² – This cost will vary on how the leverage is implemented. The cost of many risk parity approaches results from trading in more expensive underlying instruments such as reverse repurchase agreements, futures and swap transactions or certain other derivative instruments. In addition, many institutions are able to obtain this leverage inexpensively, but ultimately pass on the convenience of this exposure to clients in higher management fees. Share this article with a colleague