Explaining The Low Vol Anomaly
One of the biggest problems facing the first formal asset pricing model developed by financial economists, the capital asset pricing model (CAPM), was that it predicts a positive relationship between risk and return. Empirical studies have found that the actual relationship is flat, or even negative.
But the superior performance of low-volatility stocks was documented in the literature as far back as the 1970s—by Fischer Black, among others—even before the size and value premiums were officially “discovered.” The low-volatility anomaly has been shown to exist in equity markets around the globe. What’s interesting is that this finding is true not only for stocks, but for bonds as well.
When examining this anomaly, Robert Novy-Marx—in his September 2014 paper, “Understanding Defensive Equity,” which covered the period from 1968 through 2013—found that when ranking stocks in quintiles, either by volatility or beta, the highest-quintile stocks dramatically underperform, while the performance of the remaining four quintiles are very similar and marketlike.
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