Exploring Risk Anomaly in Indian Stock Market: The Test of Market Efficiency

Low Risk Anomaly

Mayank Joshipura

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19 March 2015

Introduction

MPT & Low Risk Anomaly

According to the Modern Portfolio Theory, there exists a direct relationship between risk and the expected return.

Riskbased Anomaly A portfolio with low volatility stocks can yield higher returns than a high-volatility portfolio.

The two strategies frequently used to exploit this risk anomaly are [a] Low volatility portfolio & [b] Minimum variance portfolio.

This study intends to employ both Low volatility (LV) & Minimum variance (MV) investment strategies to explore risk anomaly in Indian markets.

Is This Possible?

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Literature Review

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Scholars PropositionFindingsRobert Haugen (1991)First on to note the abnormality of lower-risk PortfoliosNo insight due to limited empirical supportRoger Clarke, Harvin de Silva, and Steven Thorley (2006)MV portfolios reduced volatility by 25% while delivering comparable returnsMV portfolioMarket IndexExcess Returns+6.5%+5.6%Volatility11.7%15.7%Blitz and Vliet (2007,2011)Portfolios of LV stocks areassociated with higher Sharpe-ratio Low volatility stocks (be it low beta or low standard deviation) have superior risk-adjusted returns

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Blitz & Vliet (Robeco Asset Management Quantitative Strategies)

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Regional Results

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Comparison with other investment strategies

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Blitz and Vliet (2007)

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Clarke et. al. (2006)

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Emergence of new finance!

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In the US markets, Low-volatility investing for the long term has become the latest investment philosophy after the Value, Size and Momentum investing philosophies

S&P has just announced the next launch of S&P500 LV index

Investment houses such as the Deutsche Bank in Europe and Canada, Martingale Asset management, Morgan Stanley, Analytic Investors LLC for US and Global markets, etc. have already launched funds

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All stocks Volatility QuintilesBaker, Brendan & Wurgler (Jan 1968 to Dec 2008) FAJ(2011)

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Large stocks universe

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All Stocks universe: Beta Quintiles

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Large Stocks Universe: Beta Quintiles

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BBW (2011)

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Haugen (2012)

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Haugen (2012)

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Emerging market performance

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Possible expiations for persistence

Fund managers variable component of compensation leads them to prefer high volatility stocks.

Investors indifference to outperformance during negative return period and irrational preference for outperformance during positive return periods.

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Option like management compensation model

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Relative preference for High Beta/Low Alpha over Low beta/High Alpha

Limits to arbitrage:

Restrictions on borrowing and fund mangers mandate to outperform a set benchmark dont allow arbitrage between low beta-high alpha and high beta-low alpha stocks.

Poor Fund Managers facing SAHDEV FATE!

LBOs can achieve this and thats the secret why PEs target stable, cash rich and strong balance sheet (high available borrowing capacity) firms as target.

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Problems associated with Delegated fund management with mandate of outperforming benchmark

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Behavioral Biases

Preference for high volatility stocks

Preference for lottery (low priced, high volatility stocks are considered positively skewed lottery like payoff)

Representativeness- all new technology firm IPO has Microsoft in the making!

Overconfidence-Volatile outcomes but I can predict with certainty

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