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?The Greatest Anomaly in Finance'

February 14, 2012

by Geoff Considine

If I told you that there is an easy-to-exploit market anomaly that has enabled investors to consistently and substantially outperform the market with less risk for more than four decades, your first instinct might be to roll your eyes. After all, the unending quest to improve returns while lowering risk has yielded countless methods with initial promise that subsequently collapse under further scrutiny.

Not so fast. What if I could show that this market anomaly is well-documented in the academic literature – that it is not just some esoteric theory? And that now some newly created ETFs provide a convenient way for advisors to access this strategy?

You might listen a little closer.

As you might have guessed, this is not actually a hypothetical – I’m referring to the demonstrated outperformance of low-beta and low-volatility stocks.   Since financial theory dictates that lower risk should imply lower return, this is an anomaly.

In this article, I explore the historical evidence for this powerful anomaly, explain what market mechanisms permit it to exist and persist, and examine the ETFs that exploit it to determine whether it is likely that these funds will provide future outperformance. 

”The greatest anomaly in finance”

Support for the effect I describe comes from a recent research paper by Malcolm Baker of Harvard Business School and his co-authors, who called it the “greatest anomaly in finance.”  While financial theory dictates that the only way to achieve higher returns is taking on more risk, this has not been historically true for equities.  In their 2010 paper titled Benchmarks as Limits to Arbitrage: Understanding the Low Volatility Anomaly, Baker and co-authors Brendan Bradley of Acadian Asset Management and Jeffrey Wurgler of NYU Stern School of Business found that selectively investing in portfolios of either low-beta or low-volatility stocks over the 41-year period spanning 1968 through 2008 would have resulted in annualized alphas of 2.6% and 2.1%, respectively.  The swings these portfolios experienced were also far less extreme than those of the broader market.  If the universe of stocks under consideration is limited to the 1,000 stocks with the largest market capitalizations, the low-beta and low-volatility portfolios generated 3.49% and 2.1% in annualized alpha, respectively. 

As this anomaly has become more well-known, ETFs have been specifically designed to allow investors to exploit this source of alpha.  The natural question that emerges, of course, is whether this source of outperformance will disappear as investors, recognizing this arbitrage, will exploit this anomaly until it no longer exists.  The intriguing conclusion of Baker et al. was that this effect is not disappearing. They proposed a theory that explains their observations and made a compelling case for the future attractiveness of low-volatility and low-beta portfolios. 

Baker et al. analyzed historical market data from CRSP, a survivorship-corrected historical research database of equities, and found that grouping stocks into either low-volatility or low-beta cohorts resulted in substantial future outperformance. They found this effect both when they looked at a universe of all publicly traded stocks and when they limited the universe of potential investments to the 1,000 stocks with the highest market capitalizations.