When Wells Fargo hired Fischer Black and Myron Scholes in the late 1960s to advise on its plans for the first-ever index fund, the economists made a curious discovery. The internal argument they triggered still echoes in the investment industry today.
Back then, it was the heyday of Eugene Fama’s “efficient markets hypothesis”. This stipulated that the stock market was in practice unbeatable, as all new relevant information was continually baked into prices. But professors Scholes and Black found that one could outperform by simply buying stocks with lower volatility, possibly because investors systematically overpaid for more exciting, choppier securities.
This was radical. Such a free lunch — getting both greater and steadier returns — contradicted economic dogma at the time, which dictated that one could only generate greater returns by taking on greater risks. But the data was the data, so Black and Scholes suggested that Wells Fargo set up a passive fund that would take advantage of this apparent anomaly.
Ultimately, what was going to be named the Stagecoach Fund — a homage to Wells Fargo’s storied past — foundered. The bank instead eventually pivoted to a simpler S&P 500 index fund. But the core idea lives on in what is often called “minimum volatility” strategies. Today this is a nearly $90bn corner of the exchange-traded fund industry.
Unfortunately, they have not lived up to expectations lately. The min-vol “factor” — as these investment signals are usually termed — is now the worst-performing of all the mainstream ones over the past year, after cheap value stocks and smaller shares enjoyed a renaissance. This year, min-vol has done worse than even once-hot momentum stocks, which have been trashed in the recent violent equity market rotation caused by investors betting on a post-Covid old-economy boom.
Take BlackRock’s $28bn min-vol ETF, the biggest in the field and a good proxy for how well the broader investment strategy is doing. Since the beginning of 2020 it is up about 4 per cent. The second-worst factor over that time is value, which is now up nearly 15 per cent after a powerful bounce since last autumn. MSCI’s broader US stock market index has climbed almost 25 per cent over the same period.
This is not an isolated issue, nor uniquely a US equity market phenomenon. BlackRock’s European, global and emerging-market equivalents have all markedly underperformed their respective broader benchmarks.
Although the ETFs have largely done their job in being steadier than the broader market lately, their volatility is only marginally lower. And that will be of little consolation to investors who have now somehow missed out on one of the most powerful 12-month periods for stock market returns in history. Worse for the argument that low-volatility stocks should at least in the long run deliver above-market returns, the biggest min-vol ETFs have now all underperformed their conventional benchmarks over the past decade, in some cases sharply so.
What has caused once-popular investment factor to fizzle so badly, and can it enjoy a belated blossoming?
History holds some lessons in this respect: One of the reasons why Wells Fargo never followed through on the original idea proposed by professors Black and Scholes back in the late 1960s was that Bill Fouse, one of its senior executives at the time and a pioneering quant in his own right, argued that simply buying low-volatility stocks would erode the benefits of diversification: Steadier securities tend to be found in certain stable industries. In short, he applied some common sense to what the data indicated.
It proved a fortuitous decision. If Wells Fargo had launched a leveraged, low-volatility passive fund at the time it would likely have imploded in the 1974 bear market, and might have set passive investing back by years.
Nowadays, most factor strategies strive to be somewhat sector-neutral. In other words, they try to avoid herding into just a few industries, stay somewhat diversified and not diverge too far from the overall make-up of the stock market. But in practice min-vol strategies do tend to lean heavily into some specific corners of the market, such as healthcare, consumer staples and utilities, which have underperformed lately.
However, the broader more intractable problem may simply be that the min-vol anomaly first identified by Scholes and Black — greater and steadier returns — was simply too much of a free lunch to last for ever, and has now gone the way of the dodo.