Study Indicates Low Volatility Stocks Outperform

By on May 29, 2012

Nardin Baker - Guggenheim PartnersNardin L. Baker of Guggenheim Partners Investment Management, and Robert A. Haugen of  Haugen Custom Financial Systems, conducted a study on the Low Volatility Anomaly. Their conclusion is that low risk stocks provide higher returns than riskier stocks.

Baker and Haugen attribute the outperformance of low risk stocks to “agency issues.” They believe their findings invalidate the Capital Asset Pricing Model (CAPM) and the Efficient Market Hypothesis.

The study was conducted using over 20 years of data (1990 – 2011) and the anomaly was observed in all markets they studied throughout the world (21 developed countries and 12 emerging markets).

Baker and Haugen measured risk by comparing the volatility of total return of  stocks in their universe.

Baker and Haugen found the low volatility outperformance anomaly remarkable for a number of reasons including:

“it is remarkable because it contradicts the very core of finance: that risk bearing can be expected to produce a reward.”

The agency issues of which Baker and Haugen refer to involve the investment decision making processes of investment managers and their committees. They aptly describe the reasons money managers gravitate towards newsworthy, yet riskier equities. The demand from these managers causes risky equities to become overvalued relative to lower volatility stocks.

Baker and Haugen’s 22 page research paper is available at SSRN.

Tadas Viskanta, founder and editor of the Abnormal Returns blog, conducted an enlightening two-part interview of co-author Nardin Baker; the first part of which is available at this link.

Below is a video of Nardin Baker discussing the low volatility anomaly:

Barron Maestro: Although this study is extremely interesting reading, a twenty year timeframe is probably not sufficient to serve as proof the anomaly of low volatility outperformance will continue in the future. However, the reasoning behind it is solid and investors would likely not be led astray by following its tenants in which it is apparent that true value investing is the surest way to high returns over time.

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