Monday, April 16, 2018

Why My 1994 Low-Vol Dissertation Didn't Make Impact

Pim van Vliet posted a link to my 1994 dissertation, noting it was an early documentation of the low-vol effect. One may wonder, why did this early evidence fall flat? Clearly, lots of things, but I'll try to highlight the keys.

Here's my lead paragraph, which makes clear I saw the low vol effect before most everyone:
This paper documents two new facts. First, over the past 30 years variance has been negatively correlated with expected return for NYSE&AMEX stocks and this relationship is not accounted for by several well-known prespecified factors (e.g., the price-to-book ratio or size). More volatile stocks have lower returns, other things equal. In fact, one of the prespecified factors, size, obscures this inverse relationship. Second, I document that open-end mutual funds have strong preferences for stocks that are liquid, well-known, and most interestingly, highly volatile stocks.
While I thought my dissertation found something new, true, and important, and so was unimpressed by the lack of interest in my findings. I got no 'fly-outs' to present my ideas, even though part of this dissertation led to an article published in the flagship Journal of Finance (the part on funds showing a bias towards small-cap stocks, see here). The main reason here is rather silly. I was an economics PhD, and I was interested in a finance job. The Northwestern financial department didn't find my work particularly noteworthy in part because it didn't have any good theoretical explanation, no equilibrium model consistent with utility maximizing agents. That was a constraint back then, though it isn't any longer, so that's just bad timing on my part.

You don't need an equilibrium story for empirical results anymore, you just have to say it's part of 'behavioral finance', as the popularity of Danny Kahneman and Freakonomics changed the standards. But asset pricing held out longer than most other fields, and so the seminal 'low vol' reference is  Ang, Hodrick, Xing, and Zhang (2006). The paper is mainly about trying to test a very rigorous extension to the standard model, looking at the volatility of volatility, but noted at the end the strange fact that volatility was, by itself, implied lower future returns. That finding was not the main point, just curious, but it highlights that early on, one couldn't just report something so contrary to the standard model--higher risk generates higher return--without a convincing, rigorous, explanation. Now, it's common for people just to throw in a constraint and ignore the inconsistencies with unconstrained investors, whose presence would put back the CAPM results (see here for a discussion on that).

Another issue was that I started writing my dissertation under the guidance of a game theorist, and he suggested I needed a real finance person as well. The first prof I pitched my idea to was not very receptive, and so I told him that she didn't like it. He was the Kellogg's (Northwestern's B-school) academic dean at that time, and so when he called her to ask about her reservations, she called me into her office, weeping, as she basically thought I was submarining her career by bad mouthing her. I had no idea it would be interpreted that way, but I was naive. Alas, her boyfriend at the time was the head of the finance department, so he was not going to be an advocate. Eventually, I got one finance prof on my committee, but he was a young guy without any pull among other departments.

Yet, once I did publish that JoF piece, I did have my low-vol finding make the first round at the JoF. However, my reviewer, a well-known guy, took umbrage at one of my statements in the second round and ended his review by saying not only would he not recommend my paper, but that he did not encourage me to work on this further (say, submitting to a lower tier journal). I would send papers out to other journals and got many dismissive rejections, such as one professor telling me I was trying to say the earth is flat, and one helpfully telling me they would save my submission fee by not even sending it to a reviewer. Of course, prior to 2006, if any of them were published, they would have been highly cited today.

I was heartened by the fact that most of these rejections were so strong: it wasn't found uninteresting, rather, inconceivable. This instigated me to start an actual fund based on the insight, a ' low vol' fund, and I got this started around 1996. I got a few interviews out in NYC with some big financial firms, but unfortunately, laid all my cards out on the table: invest in low vol, make an extra 2% with 3/4 the risk. With hindsight, this was a terrible pitch. To the extent one believes it's true, one can easily just take the idea and implement it. It seemed so simple, something seemed wrong. Everyone asked: but if it's true everyone would just invest in low vol stocks?

Later I applied this strategy within hedge funds, basically with low vol the main ingredient among a couple others, spread out worldwide, hedging with basic futures. It can generate a nice 1.0 Sharpe, and did for me historically. Alas, after I left one fund to do this on my own, my boss sued me for violating our confidentiality agreement, in that anything I had done there was 'his property,' so I spent much time documenting the fact that I had figured this all out before I went to his fund around 2003, and much of it public knowledge circa 2007-8. Eventually, I did get another chance to do that, and again it worked, but that multi-strat foundered for many reasons, but after that, I found most hedge funds were all looking for 2+ Sharpe strategies...

So, I'm doing something in crypto now because I think it's fascinating, and there's a lot of potential, as well as a lot of fraud.

But, in case your looking for other low vol info, here are some links:


비글 said...

It's really a shame that you are not getting the credit for the idiosyncratic volatility. I have great respect for you and look forward to your future work in crypto or elsewhere.

John said...

To the person above, I give him credit. Is that enough?

John said...

Has anyone studied whether the low-vol effect holds if you study asset volatility rather than equity volatility? Maybe if a firm has levered up, they have significantly higher equity volatility than asset volatility. In the event of a shock, the Merton model would suggest a non-linear relationship that leads to more downside risk. Low volatility firms might be either those with lower asset volatility or those with less leverage. Regardless, they might experience less of this downside risk.

Also, the whole 2+ Sharpe ratio thing is such a ridiculous ask. Why would they bother working for the hedge fund if they had those strategies? And where are all the hedge funds earning 20% returns with 10% volatility? I doubt hedge funds as an industry are above 1.