The low volatility anomaly has proved incredibly popular in recent years. Investors have moved billions into low volatility funds that dangle a juicy carrot – the potential to earn superior risk adjusted returns.

Historically, low volatility has beaten the market while exposing investors to less risk than the market portfolio.

Yet while other return premiums like value and momentum enjoy widespread support among theorists and empiricists, low volatility has taken the kind of credibility battering that’s normally reserved for the tooth fairy.

The evidence mounts

The major problem is that much of low volatility’s good run may be due to the historical quirk of a relentless 30-year decline in interest rates – a streak that can hardly be counted on in the foreseeable future.

What’s more, the popularity of low volatility funds over the past few years has led to a spike in valuations in the relevant shares – the perfect conditions for a long period of underperformance.

Passive investing champion Larry Swedroe has written extensively on the difficulties that could beset low volatility investors in the future.

He cites evidence that past success has relied upon exposure to large, stable, high-yielding value companies, as well as high concentrations in the utility and non-durable goods sectors.

Such firms are known for loading up on debt. Such debt became cheaper as interest rates fell over the decades, which boosted the performance of those companies and by extension low volatility strategies.

If real interest rates rise though, then these firms may well suffer falls in price in a similar way to long-term bonds.

Over valued

The historical characteristics of low-volatility shares might also suggest that a low volatility tracker could be a good way to gain exposure to the value premium, though such trackers haven’t yet been around long enough for us to tell.

But there’s already evidence that stable, large cap value firms could have lower expected returns than distressed small value companies teetering on the edge of extinction. That could indicate you won’t get similar rewards from low-volatility as you would from a true value fund because you’re not taking the same risks.

Plus if investing in low volatility in practice means betting big on just a couple of sectors (such as utilities and healthcare) then there’s no reason to believe that this will continue to pay off in the future. No one’s ever found a sector premium.

It all suggests to me that if you want a less risky way to pursue the value premium, you’d be better off investing in a value fund combined with a UK Government bond fund to achieve the same result: market-like expected returns at a lower risk.

This way you’d also benefit from the low correlation between equities and government bonds.

Another danger with low volatility strategies has been identified by Erik Knutzen, author of the study, Pursuing the Low Volatility Anomaly.

Knutzen shows that the money flooding into low volatility equities had inflated their prices to a 22% premium by 2012, concluding:

Expensive valuation for low volatility stocks is consistent with their strong recent relative performance and may also indicate an impending period of sustained underperformance.

In fact, in order for the track record of low volatility stocks to become consistent with the expectations we described earlier as reasonable, this category may have to experience a lengthy period of sub-par returns.

Gulp.

Practical difficulties

Meanwhile the authors of the paper The Limits to Arbitrage and the Low-Volatility Anomaly found that the low volatility premium may well persist in the data because it’s exceptionally difficult to capture in practice.

Once they factored in the real-world costs of executing a low volatility strategy (usually neglected by the academics), the authors discovered that most of the theoretical gains were wiped out.

They warn:

In short, our findings cast some doubt on the practical profitability of a low risk trading strategy.

Finally, in his paper Understanding Defensive Equity, Professor Robert Novy-Marx found that low volatility’s edge is explained by its bias against small, unprofitable growth equities, of the sort that have long proven toxic for investors. Novy-Marx demonstrates that the low volatility story does not hold up in other segments of the equity universe.

In other words, the significant outperformance of low volatility is restricted to small cap growth companies, whereas the normal, positive relationship between risk and reward is restored for small value and large cap equities.

Moreover, much of the theoretical success of low volatility strategies may well come from shorting these highly volatile and unprofitable small companies. That is something that is entirely feasible in the frictionless confines of an academic’s back-tested simulation, but which you won’t find on offer from any of the low volatility ETFs that we can actually invest in.

Novy-Marx concludes:

This is not to say that an individual would not have benefited from following a defensive strategy. Investors certainly would have profited from avoiding unprofitable small cap growth firms.

Defensive strategies are, however, an inefficient way to exploit these premia, which are better accessed directly.

Investing in value and profitability/quality funds would be one way to do this.

Take it steady,

The Accumulator

Good reads from around the Web.

I know someone looking to buy a flat in London who was astonished last week to find his low-ball opening gambit treated with some reverence.

Earlier this year our mild-mannered friends had recounted harrowing tales of being transformed into bare-toothed gazumpers by those insidious ‘open house’ days, which were blatantly designed to game frightened buyers into bidding well above the asking price (after they’d trapped the opposition couple in the box bedroom with a strategically placed Eames chair wedged under the doorknob.)

But now? Fewer viewings, no offers, and “yes, that does sound like a reasonable position to take in today’s market”.

ThisIsMoney sees a chill is coming, and it blames democracy:

It may still be six-and-a-half months before the General Election, but the market is already preparing for its traditional slowdown leading up to polling day.

Sellers know if they do not complete by Christmas, they may be stuck with their homes until well after the election, which we know will be held on May 7.

As a result, between a quarter and a third of homes on the market today have had their prices cut, with more to come.

If you prefer to hear from the frontline rather than hacks hunting for a story, then consider this week’s update from Foxtons, one of London’s swankier agents:

Although the longer term outlook for London property markets remains positive, the market is expected to continue to be constrained for some time due to political and economic uncertainty within the UK and Europe, tighter mortgage lending markets and mismatches between the price expectations of buyers and sellers.

These external headwinds have exacerbated the rate of slowdown in sales transactions we noted at the time of our H1 results.

Market volumes in Q3 have been more in line with the first half of 2013 and we now believe that market volumes in H2 2014 overall will be significantly below levels during the same period last year.

That was enough to knock roughly 20% off Foxtons’ share price, and it had already been sliding for months beforehand.

General uncertainty

I’ve heard some hedge fund managers predicting very dire things for next Spring in the UK, and while I’m not one to spread doom they might have a point when it comes to the frothy property market down south.

Their concern is that no political party is likely to win the General Election, and that all subsequent tie-ups come with uncertainties.

In particular the Conservatives seem to be talking themselves into a position where mooting a UK withdrawal from Europe is not a bogeyman to frighten the moderates but an implied plank of their manifesto. Amongst much else, it’s hard to see London continuing to suck in capital and talent in a world where we are leaving Europe. The potential alone could put off buyers, especially foreign money.

Meanwhile Labour and the Lib Dems are promising mansion taxes, which are hardly bullish for London house prices.

Add the prospect of higher interest rates and ever-tightening banking regulations and one does wonder if the trigger is here to finally pop one of the last great pre-2008 asset booms.

Merryn Somerset-Webb thinks so. In the FT this weekend in her article “The deficit will kill the property bubble” [search result] she writes:

Sooner or later, and regardless of who wins the next election, wealth taxes in the form of property taxes are going up. […]

You might not be ready to accept this yet – but the buyers of London property clearly have.

On the other hand I’ve been short one London house for far too long, and I may be clutching at straws.

[continue reading…]

Investing should be all about the long-term. Yet almost everyone who grabs our attention when it comes to investing – media pundits, asset managers, brokers – have an incentive to keep us guessing about the state of the market, and the performance of individual shares and funds.

• Magazines and websites want us to tune in and ideally pay up to hear the latest news and views.

• Fund managers want us to recognise their apparent skill and then switch to their funds.

• Brokers want us to trade our holdings. And then to trade them again.

• Even non-financial companies may benefit from a febrile atmosphere if they need to tap the markets through rights issues, IPOs, or spin-offs.

Heck, even the tax man would probably prefer we churn our portfolios. In the UK most share purchases are liable for stamp duty tax, and most investments sold for a gain outside of ISA or pension face capital gains tax, too.

Whatever you do, don’t do it

There are big problems with being too concerned about the meanderings of the stock market when you’re a private investor.

Active investors who are overly obsessed with day-to-day market noise and commentary are more likely to feel the need to do something – which usually means trading shares or swapping funds their around.

Too much of trading increases expenses and will likely reduce your returns. And most of the time, when people swap funds they are chasing performance, which can have a damaging impact over the long-term, as they repeatedly sell low and buy high.

Yet even passive investors can suffer if they’re partial to weather reports and horoscopes stock market updates and analysts’ commentary.

A well-balanced asset allocation can be derailed if you react to some super-smooth pundit opining about asset classes, touting that “only a fool would own government bonds right now” or claiming that “This is surely a once in a lifetime chance to invest in the Democratic Republic of Congo!”

Then there’s the worst fate of all – being scared out of your positions at the bottom of a bear market, and missing out on the rebound.

Stick to the plan, Stan

Sticking to your long-term plan is vital for success, as this video from Sensible Investing TV explains:

As Vanguard founder Jack Bogle says:

“Why in the name of peace do we pay any attention to the stock market? The stock market is a derivative.

The stock market is a derivative of what? It’s a derivative of the earning power and dividend yields on, in the case of this nation, US corporations.

The dividend yield, plus the earnings growth that follows, is what creates the fundamental return on stocks.

The speculative return on stocks, compared to that investment return, is how much people are willing to pay for a dollar of earnings.

That carries the market up and down, and in the long run, in the last 100 years, the contribution of speculative return to total market return is zero.

The contribution of investment return, if you happen to have 4.5% dividend yield and 4.5% earnings growth, that’s the 9% you read about in the past for the US market.

Bogle’s conclusion? The stock market is a giant distraction to the business of investing.

Most people are best off ignoring it like you’d ignore the tantrums of a greedy and tired child, and letting long-term compound interest work its magic.

Check out the rest of the videos in this series.