The high returns to low volatility stocks are actually a premium on high quality firms

• Date: 01 November 2013
• Published date: 01 November 2013
• DOI: http://doi.org/10.1016/j.rfe.2013.06.001
• Author: Christian Walkshäusl

The high returns to low volatility stocks are actually a premium

on high quality f‌irms

Christian Walkshäusl ⁎

University of Regensburg, Center of Finance, Universitätsstraße 31, 93053 Regensburg, Germany

abstractarticle info

Article history:

Received 19 April 2013

Received in revised form 14 June 2013

Accepted 18 June 2013

Available online 28 June 2013

JEL classif‌ication:

G11

G12

G15

Keywords:

Volatility effect

Quality investing

Asset pricing

International markets

Recent empiricalresearch shows that low volatility stocksoutperform high volatility stocks aroundthe world.

This study documentsthat the volatility effect isassociated with the quality of the f‌irm usinga large sampleof

internationalstocks. First, adding a quality factorto the Fama–French model contributes to the explanation of

the volatilityeffect. Furthermore, the negativevolatility–return relationis shown to be stronger and signif‌icant

only among high qualityf‌irms which are prof‌itable and have stable cashf‌lows. Second, a fundamental invest-

ment strategy that goeslong high quality f‌irms and short low qualityf‌irms performs like a volatility strategy

and cannotbe explained by common assetpricing models. However,a low–high volatility factoradds to the ex-

planationof the return differencebetween high and low quality stocksas volatility and qualitystrategies have a

common component.

© 2013 Elsevier Inc. All rights reserved.

1. Introduction

A large numberof recent empirical researchdocument that low vol-

atility stocks have higher average returns than high volatility stocks

around the world.

1

The outperformance of low volatility stocks over

high volatility stocks is economically exceptionally large, amounting

on average to 12% per year. Baker, Bradley, and Wurgler (2011, p. 43)

therefore arguethat “the outperformance of low-risk portfolios isper-

haps the greatestanomaly in f‌inance”.

Risk-based explanations have problems in describing the observed

return pattern, as the return difference between low and high risk

stocks cannot be captured by common asset pricing models. This is

mainly due to the fact that low volatility stocks have typically low

market betas, whereas high volatility stocks exhibit high market

betas. Blitz and van Vliet (2007) therefore argue that low risk stocks

should be considered as a distinct asset class in the strategic asset al-

location process.

Ang, Hodrick, Xing, and Zhang (2006, 2009) rule out a large num-

ber of possible explanations for the observed volatility effect in U.S.

and international returns. They provide evidence that explanations

basedon aggregate market volatilityrisk, microstructuremeasures,dis-

persion in analysts'forecasts, costs of trading,and information dissem-

ination cannot explain the negative volatility–return relation around

the world. Baker et al. (2011) offer behavioral explanations for this

anomaly. They arguethat the volatility effect may be partly explained

by the irrational preference for high volatility stocks by individual in-

vestors andthe institutional investor'smandate to beat a given bench-

mark which limitsinvestments in low volatilitystocks.

In this paper,we examine a large sample of internationalf‌irms with

two goals.First, we documentthat the volatility effect,the empirical ev-

idence of high returns to low volatility stocks, is associated with the

quality of the f‌irm as measuredby prof‌itability and cashf‌low variability.

Second, we propose a fundamental investment strategy based on the

quality of the f‌irm that performs like a volatility strategy and present

evidence that volatility and qualitystrategies have a common compo-

nent in international markets.

In the f‌irst part of the paper, we show thatt he highreturns to low vol-

atility stocks are associated with the quality of the f‌irmin f‌inancial terms.

After having established the puzzling negative volatility–return relation

in international markets, we create at f‌irst a quality factor based on prof-

itability or cash f‌low variability that we use as the fourth factor to the

Fama–French model, extending it to a quality-enhanced four-factor

model for explaining the return behavior of volatility portfolios. In line

with Huang (2009), we use cash f‌low from operations as a proxy for

the f‌irm's economic earnings as accounting earnings may underestimate

Review of Financial Economics 22 (2013) 180–186

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1

See, for instance, Ang et al. (2006, 2009),Clarke, de Silva, and Thorley (2006),Blitz

and van Vliet (2007),Baker et al. (2011), and Baker and Haugen (2012). However, Bali

and Cakici (2008) f‌ind for the U.S. that the volatility effect is weaker when volatility

portfolios are equal-weighted and when the volatility variable is estimated using

monthly instead of daily data.

1058-3300/$ –see front matter © 2013 Elsevier Inc. All rights reserved.

http://dx.doi.org/10.1016/j.rfe.2013.06.001

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