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No Pain, No Gain? The Puzzle of Risk-Return Relationship

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Abstract

The relationship between risk and return in finance seems controversial. While the crucial implication of the standard models dictates—the higher the risk, the higher the expected return—the empirical evidence seems to contradict this expectation. Emerging evidence has proven that the standard measures of realized risk, including volatility or systematic risk, negatively predict abnormal returns. Surprisingly, some other measures related to tail risk or downside risk have proven as positive predictors of performance. Importantly, all the measures might help investors to predict abnormal returns. In this chapter, the authors carefully reviewed the risk-based return-predictive signals along with their theoretical and empirical evidence and conducted thorough tests of example strategies across 24 international equity markets.

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Notes

  1. 1.

    The detailed characteristics of the Sharpe model was extensively presented in a number of financial textbooks, for example, Francis (1990), Elton and Gruber (1995), Campbell et al. (1997), Cochrane (2005), or Wilmott (2008).

  2. 2.

    Treynor (1961, 1962), Lintner (1965a, b), and Mossin (1966) developed a similar model at the same time, so all four of them, including Sharpe (1964), are now considered to be the fathers of the CAPM model.

  3. 3.

    Examples include Black et al. (1972), Fama and MacBeth (1973), Blume (1970), Miller and Scholes (1972), and Blume and Friend (1973).

  4. 4.

    See Levy (1978), Tinic and West (1986), Merton (1987), and Malkiel and Xu (1997, 2004).

  5. 5.

    The issues discussed in this section have been also described in Zaremba (2016a).

  6. 6.

    For the US equity markets, see Black (1993), Haugen and Baker (1991, 1996), Falkenstein (1994), Chan et al. (1999), Jagannathan and Ma (2003), Clarke et al. (2006), Ang et al. (2006b), and Clarke et al. (2010); for global equity markets, see Blitz and van Vliet (2007), Ang et al. (2009), Baker et al. (2011), Dimitriou and Simos (2011), Baker and Haugen (2012), Blitz et al. (2013b), and Walkshausl (2014a, b).

  7. 7.

    The evidence is provided in the following studies: for commodities, Blitz and de Groot (2014) and Szymanowska et al. (2014); for treasury bonds, de Carvalho et al. (2014), Zaremba and Schabek (2017), and Zaremba and Czapkiewicz (2017a, b); for corporate bonds, Houweling et al. (2012), de Carvalho et al. (2014), Houweling and Zundert (2014), and Ng and Phelps (2015). Some papers also find evidence for the low-volatility effect appearing in country equity indices, but this evidence is not very convincing. It rather seems in line with the theoretical expectations of the classical models; these are the risky markets, which yield higher returns. In early 1996, Erb et al. compared the returns and volatilities across a panel of 28 equity market indices within the years 1979–1995. They discovered the relation between these two metrics rather weak, albeit generally positive, particularly among the emerging equity markets.

  8. 8.

    See Liang and Wei (2016) and Zaremba (2016b) for further evidence.

  9. 9.

    See Liang and Wei (2006) or Zaremba (2016b).

  10. 10.

    A review of relevant studies is provided by Alexeev and Tapon (2012).

  11. 11.

    See Merton (1987) and Malkiel and Xu (2004).

  12. 12.

    For further evidence, see Bali and Cakici (2008), Fu (2009), Clarke et al. (2010), van Vliet et al. (2011), and Fink et al. (2010).

  13. 13.

    See Bernard et al. (2013), Fernandez-Perez et al. (2014), or Fuertes et al. (2015).

  14. 14.

    Further evidence on the relationship between idiosyncratic volatility and future returns in the cross-country section can also be found in Hueng and Yau (2013).

  15. 15.

    For references on various measures of profitability, see, for example, for the gross-profitability , Novy-Marx (2013); Fama and French (2006), Balakrishnan et al. (2010), and Kogan and Papanikolaou (2013); for ROE, Haugen and Baker (1996), Chen et al. (2011a), and Wang and Yu (2013).

  16. 16.

    For evidence, see Lakonishok et al. (1994), Chan et al. (2001), Fairfield (2003), Titman et al. (2004), Eberhardt et al. (2004), Gu (2005), Anderson and Garcia-Feijoo (2006), Cooper et al. (2008), Hirshleifer et al. (2013), and Lou (2014).

  17. 17.

    http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html.

  18. 18.

    https://www.aqr.com/library/data-sets.

  19. 19.

    For further readings on these types of measures, see Goyal and Santa-Clara (2003), Bali et al. (2005), Bekaert et al. (2012), Garcia et al. (2014), Verousis and Voukelatos (2015), and Kim and Lee (2017).

  20. 20.

    For Taiwan, Chen et al. (2014); for Pakistan, Iqbal et al. 2013, Iqbal and Azher (2014); and for hedge funds, Bali et al. (2007).

  21. 21.

    For various measures, see Goyal and Santa-Clara (2003), Bali et al. (2005), Bekaert et al. (2012), Garcia et al. (2014), Verousis and Voukelatos (2015), Kim and Lee (2017), and Zaremba and Andreu Sanchez (2017).

  22. 22.

    For evidence, see, for leverage and credit standing, Penman et al. (2007), Campbell et al. (2008), Hahn and Lee (2009), and George and Hwang (2010); for growth, Mohanram (2005); for accruals, Sloan (1996), and Richardson et al. (2005); for balance sheet liquidity, Palazzo (2012); for profitability, Griffin and Lemmon (2002), Fama and French (2006), and Novy-Marx (2013); and for aggregated measures, Asness et al. (2017).

  23. 23.

    This section has been inspired and sourced from Zaremba and Shemer (2017).

  24. 24.

    Interestingly, some studies argue low-volatility anomaly to be just a manifestation of various skewness related effects; see, for example, Schneider et al. (2016).

  25. 25.

    See, for example, Tversky and Kahneman (1992), Barberis and Huang (2008), or Bali et al. (2011).

  26. 26.

    Seminal papers on this issue include Fischhoff et al. (1977) and Alpert and Raiffa (1982).

  27. 27.

    For example, Ferrer-i-Carbonell (2005), Luttmer (2005), Clark and Oswald (1996), and Knight et al. (2009).

  28. 28.

    See Abel (1990), Gali (1994), Campbell and Cochrane (1999), Heaton and Lucas (2000), Lettau and Ludwigson (2001), DeMarzo et al. (2004), or Roussanov (2010).

  29. 29.

    See Sharpe (1981) or Roll (1992).

  30. 30.

    For further models and references, see Falkenstein (2009, 2012), Blitz et al. (2013b), and Brennan et al. (2012).

  31. 31.

    See, for example, Brennan (1971), Black (1972, 1993), and Frazzini and Pedersen (2014).

  32. 32.

    The evidence is provided by, for example, Bali and Cakici (2008) and Han and Lesmond (2011).

  33. 33.

    Importantly, in this exercise we first averaged the time-series of log-returns and subsequently converted it into the standard returns.

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    Adam Zaremba

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    Jacob “Koby” Shemer

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Zaremba, A., Shemer, J.“. (2018). No Pain, No Gain? The Puzzle of Risk-Return Relationship. In: Price-Based Investment Strategies. Palgrave Macmillan, Cham. https://doi.org/10.1007/978-3-319-91530-2_4

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