Low-risk equity investment – From theory to practice

Abstract

Financial theory assumes that higher risk is compensated on average by higher returns. However, the outperformance of low-volatility stocks during the last 50 years has been among the most puzzling anomalies in equity markets. At the same time, low-risk investing has recently gained a remarkable interest, due to its documented performance coupled with the unprecedented volatility experienced during the last global financial crisis. The section ‘Literature Review’ of our study discusses how researchers have been documenting such anomaly and explaining (since the early nineties) this phenomenon with theories referring to leverage constraints, behavioral bias, delegated portfolio, benchmarking and the utility function of fund managers. Recognizing that most of the available empirical research focuses on the US equity market, section ‘Empirical Evidence in the International Arena’ is dedicated to some additional tests that we have run on the persistency and significance of the anomaly in the international arena: We find that the relationship between risk-adjusted returns and risk is negative indeed, and that the relationship holds regardless of the risk measure employed for tests (Beta or volatility). In section ‘Can Skewness And Convexity Explain the Low-Risk Anomaly?’, we investigate two possible explanations of the anomaly related to the distribution of equity returns, namely skewness and convexity. We find that high-risk stocks exhibit higher skewness and higher convexity than low-risk stocks. These results may effectively explain the anomaly because, if the price paid for stocks with higher-than-average skewness and convexity is inflated, their subsequent returns are consequently lower-than-average, at least in risk-adjusted terms. In the last section of our research, we discuss two popular risk-based smart beta strategies (minimum variance and risk parity) proving that both of them benefit from the low-risk anomaly via a significant and systematic bias toward low-risk stocks. We ultimately discuss some best practices of implementing the minimum-variance process, and provide an effective and parsimonious portfolio construction rule for the risk parity process.