Low volatility rally raises big questions

Low volatility, high risk?

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The S&P 500 Low Volatility Index, mimicked by the popular PowerShares product (SPLV), has enjoyed a great run over the past few years. Because despite only tracking 53 percent of the S&P 500's moves on paper (according to a popular metric called "beta"), the ETF has risen nearly as much as the S&P itself since inception in May 2011.

For many capital markets professionals, this is a deeply confusing fact. After all, potential reward is supposed to compensate investors for taking on risk, in one of the key concepts undergirding modern financial market theory.

In fact, noting its outperformance versus the expectations of traditional capital markets theory, some traders say that low volatility names, and the (SPLV) in particular, is set to drop sharply. The S&P 500 Low Volatility Index, which the ETF tracks, is made up of the 100 S&P 500 stocks that have been least volatile over the last year, with quarterly rebalancing.

"It's really outperformed because everyone wants to be in it," said Dennis Davitt of Harvest Volatility Advisors. "These are crowded trades. And as people un-crowd out of them, these perceived low-volatility names are the first thing they're going to sell. So they will fall even more than the market as a whole" in a correction.

But there's an alternative explanation.

According to John Feyerer, vice president of ETP Product Management at Invesco PowerShares, the success of the company's product is a function of the failure of the capital markets theory. While the famous Capital Asset Pricing Model states that expected returns are a function of exposure to overall market risk, represented by the stand-in "beta," Feyerer says that this simply isn't borne out by the data.

"Investors have shown a propensity to want to have the confidence to buy higher volatility stocks. It's like a lottery ticket—the expected value is obviously negative, but people buy them anyway. That transers to an investing mentality," he told CNBC in a Monday phone interview, referring to several independent research reports.

In other words, it is possible that investors are compensated for not taking on risk, rather than taking on risk.

"Over longer periods of time, not only do low-volatility stocks outperform on a risk-adjusted basis, but even on an absolute basis, as well," he said. "Financial theory should say that's not the case, but the data is the data."

"It totally flies in the face of everything we learn in the first year of our MBA studies or in CFA Level 1, which is that low volatility should equal low return," commented Nicholas Colas of Convergex.

Of course, over time, theories are adjusted or disproved. Whether the Capital Asset Pricing Model, one of the most widely followed models in finance, will soon be considered obsolete is yet to be seen.

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