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High Returns from Low Risk - Low Volatility Effect

Hi Folks,

Here is my implementation of low volatility effect phenomenon. The anomaly is that stocks with low risk and low volatility earn abnormally high risk adjusted returns. This is opposite to the conventional wisdom of risk-return tradeoff principle. 

In the book “High Returns from Low Risks: A remarkable stock Market Paradox” Pan Van Vliet and Jan De Koning demonstrate what happens if you had the possibility to invest $100 in each a low-risk or a high-risk equity portfolio back in 1929. By 2015 the low-risk portfolio beats the high-risk portfolio in US equity market by a factor of 18. Similar phenomenon is also noticed in European, global and even emerging markets. There are many notable people who have discovered this paradox including Nobel prize winner Fischer Black. 

In the paper “The Volatility Effect: Lower Risk without Lower Return” co-authored by Vliet, authors argue that the reasons for this effect can be:

  1. Leverage is needed by the low-volatility portfolio to match the market volatility to fully utilize the attractive absolute returns of low risk stocks. But there are institutional restrictions on leverage.
  2. Inefficient investment processes. Managers usually overpay for high volatility stocks in the hope of higher returns in bull market.
  3. Behavioural biases of private investors. This is linked to the classical risk-return theory.

This implementation is fairly simple.

  1. The top hundred stocks based on trading volume are chosen as the universe.
  2. We keep track of the volatility of stocks for past 600 days. 
  3. Every month we pick two least volatile stocks from the universe and invest half of our money in each of them.
  4. We liquidate the portfolio at the end of each month.

The only drawback of this strategy that I came across is that the low-volatility portfolio have the tendency to lag the market during steep bull market rallies. I would love to know your thoughts about this strategy and please check out my video presentation of this strategy on YouTube

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nice
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Can we see how it performs in the bear market of 2007-09? Showing a 7 year bull market backtest doesn't really show much. I like the thought process though!

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Very good point....but Cloning and testing with the date by himself would have answerd the question within minutes,  

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