Should investors focus on relatively wild (high-volatility) or tame (low-volatility) stocks in emerging stock markets? In their April 2012 paper entitled “The Volatility Effect in Emerging Markets”, David Blitz, Juan Pang and Pim van Vliet examine the empirical relationship between risk and return in emerging equity markets. At the end of each month, they form equally-weighted quintile portfolios of emerging market stocks ranked separately on: (1) lagged volatility (standard deviation of total monthly returns in local currency over the past 36 months); and, (2) lagged beta (from regression of total monthly returns in U.S. dollars versus the appropriate S&P/IFCI country market index over the past 36 months). They make portfolios country-neutral by distributing each country’s stocks evenly across quintiles. They calculate annualized arithmetic and geometric average returns, volatilities and Sharpe ratios for the quintile portfolios based on their monthly total returns in U.S. dollars in excess of the one-month Treasury bill (T-bill) yield. Using monthly total returns in local currencies and U.S. dollars for stocks from 30 emerging markets (an average of about 1,000 stocks per year) during December 1988 through December 2010, along with the contemporaneous T-bill yield, they find that:
- Based on either lagged volatility or beta, past risk strongly predicts future risk for emerging market stocks. Stocks with relatively low (high) past volatility and beta tend to have relatively (low) high volatility and beta in the future.
- Future return relates negatively to lagged risk among emerging market stocks, more strongly for volatility than beta as the measure of risk. Specifically:
- The fifth of stocks with the highest lagged volatilities underperforms the fifth with lowest lagged volatilities by an annualized 4.4% geometrically (2.1% arithmetically). As a result, the Sharpe ratio of high-volatility stocks is less than half that of low-volatility stocks (0.29 versus 0.64).
- A hedge portfolio that is long (short) the fifth of stocks with the lowest (highest) lagged volatilities outperforms the emerging markets index by 8.8% per year, with most of the alpha from the short side. Three-factor (market, size, book-to-market) annual alpha is 5.7%. Four-factor annual alpha (adding momentum) is a statistically insignificant 3.1%, suggesting overlap of volatility and momentum effects.
- Results for lagged beta are similar but weaker than those for lagged volatility. A hedge portfolio that is long (short) the fifth of stocks with the lowest (highest) lagged betas outperforms the emerging markets index by 5.4% per year.
- Volatility alpha is robust to:
- Removal of the 50% of stocks with the smallest market capitalizations.
- Extending the hedge portfolio holding interval from one month (8.8%) to one year (7.3%), three years (6.3%) and five years (4.4%).
- Subperiods of 1989-1999 (3.1%) and 2000-2010 (14.4%), consistent with the hypothesis that volatility-seeking institutional investors drive the effect by overpricing high-volatility stocks.
- Low correlation between the volatility effects in emerging and developed equity markets argues against an underlying global risk factor.
- Among the 19 country markets with enough data for standalone analysis, 15 volatility hedge portfolios outperform local stock markets by at least 5% per year.
In summary, evidence indicates that a significant, robust and distinct premium accrues to low-volatility stocks within emerging markets that strengthens over time, consistent with overpricing of high-volatility stocks by institutional investors.
Cautions regarding findings include:
- Measuring volatility at different frequencies and different lagged intervals may affect results.
- Returns and Sharpe ratios are gross, not net. Including reasonable trading frictions would reduce reported returns. Trading frictions may be relatively high in emerging markets.
- Costs of shorting would also reduce reported hedge portfolio returns, and shorting of some emerging market stocks may not be feasible. The importance of the short side of the portfolio elevates these concerns.
See also the closely related “Low Risk and High Return?”, addressing developed markets.
