How Much Popularity Can Low Volatility Stand?

How Much Popularity Can Low Volatility Stand?

Date: November 11th, 2013 | Category: EquitiesStrategy

Craig Lazzara

Global Head of Index Investment Strategy

S&P Dow Jones Indices

The low volatility anomaly — i.e., the tendency for low-volatility or low-beta portfolios to outperform market averages — has been the subject of at least 40 years of academic research.  Given its challenge to what “everyone knows” about risk and return, it’s a fertile field for both professors and practitioners, some of whom recently characterized “the long-term outperformance of low-risk portfolios [as] perhaps the greatest anomaly in finance.”But anomalies, especially ones that suggest higher return and lower risk, attract investor dollars, and enough investor dollars often spell the end of anomalies.  It’s been suggested that “the low-volatility anomaly may [be] eliminated by its popularization.”

So how much popularity can low volatility stand?  Before we can suggest an answer to this question, we have to understand the source of the low volatility anomaly.  Perhaps the simplest and most intuitive explanation comes from behavioral finance, specifically from the cognitive bias that behavioral economists call the “preference for lotteries.”  Their argument is that no rational person would ever buy a lottery ticket, since the expected return of such a purchase is negative.  But billions of lottery tickets are sold all over the world every day.  Why do so many people behave in a way that classical economics can only regard as completely irrational?  The behavioral argument is that some people are willing to risk a known amount of money in exchange for the possibility, however slim, of a gigantic payoff.

If this happens in a game of pure chance, how does it apply to financial markets?  The stock market’s lottery tickets are the stocks of highly volatile, often young and untested, companies.  Ultimately, they may not amount to much, but one of them could be the next Apple or Google.   Some investors are willing to pay up for the chance of that sort of large reward — in effect buying volatility for volatility’s sake.  Low volatility strategies benefit by avoiding other investors’ volatility-seeking behavior.  We can estimate the capacity of low vol if we can estimate the extent of of volatility seeking on the other side of the trade.

Last week witnessed the much-anticipated initial public offering of Twitter, Inc., a young and volatile company if ever there was one.  The IPO price was $26; the stock closed its first day of trading (November 7) at $44.90, which implied a total market value of approximately $25 billion.  For illustrative purposes, let’s assume that $26 is a sober estimate of TWTR’s fair value (after all, the presumably well-informed selling shareholders were willing to sell there).  Then arguably the $18.90 first day’s appreciation represents the action of volatility-seeking investors.  That’s 42% of TWTR’s closing first-day valuation, or better than $10 billion.

Granted, this is a simple example with some perhaps-unrealistic assumptions.  But it gives us at least a rough gauge with which to answer our question about the capacity of low volatility strategies.  One company, in one day, produced $10 billion in volatility-seeking market value.  That’s more than the total market value of the two largest U.S. low volatility ETFs.  Whatever the ultimate capacity of low volatility strategies is, we’ve got a long way to go.

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (, the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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