Over the last few years, I have written several times about the myth of more risk equaling more reward, explaining that, historically, the opposite has been true: low-volatility sectors and strategies have outperformed more volatile sectors and strategies.
In January, after publishing “Why Low-Vol Strategies Make Sense Now“, I was pleasantly surprised by an email from Jan de Koning of Robeco in the Netherlands, who, along with Pim van Vliet, PhD, manages a multi-billion dollar fund based on the low-volatility ‘paradox.’ Jan had come across my article, and was kind enough to share the knowledge on low-volatility investing that he and Pim have accumulated over the years. To make a long story short, Jan and Pim are experts on low-volatility investing, and after reading their wonderful book on the topic, I invited them to do a brief Q&A about their findings, which Pim was kind enough to do here.
LH: How did you first become aware of the low-volatility “paradox,” as you call it, and why did you decide to shape your career around it?
PVV: Back in 1997 I first read an academic paper by Robert Haugen. He was one of the first who discovered this ‘market anomaly’ or ‘paradox’. I was 19 years old and had several years of experience with stock market investing. This academic result fascinated me since I believed that markets should be efficient. And that a higher risk should give a higher return. However, the data did not fit this theory, which was an amazing finding. And I was also struck by how little attention was given to this ‘inconvenient truth’ in the academic papers. I directly liked this kind of empirical stock market research. During my PhD thesis from 2000 to 2004 I tested if downside risk could explain these anomalous market findings. I tested low-risk, size, value and momentum. I found some predictive power, for short-term models with strong downside risk aversion. When I joined Robeco in 2005 I found that value and momentum were well known in the industry and exploited, low-risk was not. I soon discovered that tracking error and career risk were serious limits to arbitrage this low-volatility effect. And then we started building a multi-factor conservative equity strategy around this central idea. Today we manage more than 20 billion USD for clients all over the world, from California, to Texas to the East coast, Europe, the Middle East, Japan, greater China, and Australia. I’ve also published many academic papers on this topic, with the most recent one coming out in March 2018. Finally, I’ve also published the story about the paradox in a book, available on Amazon. I did this with Jan de Koning in 2017 and it is published by Wiley.
LH: The low-volatility phenomenon is well-documented not just in U.S. stocks, but also in foreign stocks, including EM. Why do you think it persists despite this?
PVV: The low-volatility ‘paradox’ is very persistent across markets and through time. In fact the anomaly is getting strong over time. Most alphas get smaller due to arbitrage this factor is not. For example, in Emerging markets we also found this effect to be present, and get stronger over time. Important is that within markets investors are overpaying for risk. It’s everywhere. It’s driven by our behavior. First, our emotions make us overconfident and pay too much for volatile stocks. Second, our incentives around benchmarks make investors pay too much for volatile stocks. Careers and payments are convex, which means a higher volatility gives a higher payout. So for professional managers it pays off to take risk. But this is a classical conflict of interest between asset owner and asset manager. Because incentives are so strong and the anomaly difficult to arbitrage away, we believe that this low-volatility phenomenon is very likely to persist in the future. I also write extensively about this in the book linking this anomaly to ancient wisdom and insights from philosophers such as Kierkegaard in ‘High returns from low risk: a remarkable paradox’.
LH: You describe how adding momentum and ‘income’ to low-volatility makes a powerful combination. Why are these factors more critical than others?
PVV: We say, buy them stable and buy them strong. The income factor elegantly combines profitability with classical valuation. When the price is low, the yield goes up. This proven value factor works very persistently across markets and through time. It is especially strong in the long-term. When a company is profitable, there is often ‘moat’ driving this and investors tend to underreact to this good news. If management is prudent then they distribute these profits to shareholders. In general, buying back shares or paying dividends is a very strong factor as well. Taken together, net payout yield is empirically stronger than most other stand-alone value factors. Momentum is a very strong factor as well. It helps to better keep up in up markets reducing the ‘pain’ for investors in a defensive strategy. Furthermore it helps to increase returns and create more diversified portfolios. Finally, momentum also helps to avoid value traps and reduces downside risk. On a stand-alone basis, this factor is quite difficult to arbitrage since turnover is easily 100% or more. Within a defensive strategy the factor works out great. With a limited amount of turnover this quick factor can be partially harvested quite easily. In our most recent academic paper we show that the ‘conservative formula’ could offer investors easy access to the best academic factors out there. As described in the Wiley book, these factors give a gross return of 15 percent per year over the past 90 years.
LH: When building a portfolio of low-volatility stocks with good income and momentum, how do you prefer to weight the portfolio, and how often do you rebalance?
PVV: In the paper and the book we apply quarterly rebalancing and restrict ourselves to the largest 1,000 stocks. In practice this can be done much more efficiently. Rebalancing could be done at a higher frequency, but with smarter sell rules and prudent concentration limits. In that way liquidity throughout the year is used and not only using liquidity around the rebalancing dates four times a year. Combining these smart trading rules with optimal use of liquidity helps to efficiently maintain the highest exposure to low-volatility stocks with good income and momentum. Finally, in our Robeco funds we have ‘cash flow optimized’ rebalancing in place. In case there is inflow, we buy the best stocks, not the stocks currently in portfolio which were bought about 2 years ago. In case there is outflow, we sell the less attractive stocks. This helps to maintain efficient factor exposure and bring turnover and trading costs down significantly. Some of our funds have had lower turnover than passive funds! This really brings down cost for our clients and is tax efficient in some countries as well.
LH: How can investors access your book and your recent paper?
PVV: The book is written for a broad audience and contains personal stories, anecdotes and easily explained evidence-based investing techniques. I wrote it in a way I could explain it to my dad, an entrepreneur with practical investing experience. It is available across the world and available in four languages: English, German, French, and Spanish. Chinese is coming up, too. It is one click away in any online bookstore. We also share the data online on our book website: www.paradoxinvesting.com
The paper is more academic and drills deeper, with some rigorous testing also comparing the results with other factors and provides international evidence. This paper is available free of charge on SSRN:
I would like once more to thank Jan and Pim for reaching out to me, and especial thanks to Pim for taking the time to cover these important topics here. I encourage you to read both the book and the paper as doing so will raise your investment IQ.