The Remarkable Stock Market Paradox of Low-Volatility Premium

Pim van Vliet, PhD, is the author of High Returns from Low Risk: A Remarkable Stock Market Paradox, with Jan de Koning.

The low-volatility premium has been one of the most compelling anomalies in financial markets, where less risky securities consistently outperform their riskier counterparts over the long term. This phenomenon, first identified in empirical tests of the capital asset pricing model (CAPM), continues to puzzle experts and remains a poorly understood reality to this day.

What makes the low volatility factor unique is its defiance of a risk-based explanation, which challenges the traditional theories of efficient markets. While academics may struggle to accept its significance, practitioners face obstacles in capitalizing on the factor due to high risk levels, leverage constraints, and potential career risks.

Despite these complexities, the low-volatility factor remains resilient and robust, standing out in the expanding “factor zoo.” By applying Occam’s razor, we uncover the simplicity that drives the significance of low volatility, as depicted in the graphic below that illustrates its interaction with other factors.

This journey through various factors, such as the Fama-French three-factor model, investment, profitability, and momentum, highlights the enduring strength of the low volatility factor. Despite multiple cuts or slices, the factor maintains its alpha, showcasing its resilience and importance.

The Starting Point: CAPM

Using data from July 1940 to December 2023, the volatility factor, measured akin to a Fama-French style factor, demonstrates a low volatility premium with a significant CAPM alpha. Amidst critiques and challenges, the low-volatility anomaly stands firm.

Low-Volatility Premium (VOL) Controlled for Other Factors, July 1940 to December 2023

Sources: The Kenneth R. French Data Library and Paradox Investing