Sure, there are periods where low-vol underperforms. This year, a calmer version of the S&P 500 has lagged the broader benchmark by about 2.7 percentage points. Yet quants point to its long-term success. Since 2000, the factor has bested the S&P 500 by a whopping 121 percentage points.
Hedge funds, it would seem, have missed the memo. Maybe it’s for good reason.
Managers succeed by locating overlooked companies, that while unpredictable and volatile, may eventually turn out large gains, said Benjamin Dunn, president of the portfolio-consulting practice at Alpha Theory.
“You need earnings variable to really drive alpha and have an edge over other investors,” Dunn said. “You’re not going to pay someone 2 and 20 to be long General Mills.”
Low-Vol Risk
Explicitly tracking the low-vol factor also comes with its own challenges, especially overcrowding. In 2016, a volatility blow-up was blamed on investors who piled into the strategy and then rushed for the exits. More recently, JPMorgan Chase & Co.’s 2018 outlook flagged richly priced low-volatility stocks as a source of equity-market risk.
“We’ve had a lot of questions from clients asking if this low-volatility factor was being arbitraged away, because you’d expect it to disappear if more people are exploiting it,” Blitz said. “But on the other side of the trade seems to be $3 trillion in hedge-fund assets.”
Since Robeco’s study looked at aggregate returns and not individual holdings, it is possible that some funds do track low volatility. But not enough to sway the total bias.
As for why hedge funds gravitate toward stocks with large swings, Blitz blames performance fees that incentivize managers to take riskier bets.
It’s a tad ironic. More so than most other active managers, hedge funds are in a prime position to take advantage of the low-vol anomaly. For example, they have fewer leverage constraints, so can buy the boring stocks, deploy debt, and post higher returns.