Remember those kids in high school who did everything better than you? They captained three sports teams, beat you on every math test, dated the Prom Queen, and would pop up in school musicals once in a while, if only to prove to you (or so you thought) that they were the Leonardo Da Vinci of 17-year olds? Malcolm Baker is the 42 year-old version of that kid.
Baker is currently the Robert G. Kirby Professor of Business Administration at Harvard Business School but, of course, he is so much more. Before he got his PhD from Harvard, he got his MPhil at Cambridge University. Before he got his MPhil, he rowed in the Olympics for the United States, placing fourth. Before coming fourth in the Olympics, he got his undergraduate degree at Brown. For all we know, before Brown he probably invented cold fusion, but things like that can get lost in such a ludicrously impressive resume.
What is not lost about Baker (whose disarming humbleness belies his vast accomplishments) is this: Along with Brendan Bradley and Jeffrey Wurgler, he recently won the CFA Institute’s Graham and Dodd Awards of Excellence for 2011 for their paper, Benchmarks as Limits to Arbitrage: Understanding the Low-Volatility Anomaly. “The paper started with an empirical fact,” Baker told me during a recent conversation. “It then proceeded to a kind of ‘what is the potential rationale, and how likely is it to persist?’” Very likely, the authors found.
The main thrust of the paper is that low-volatility stocks consistently outperform their high-volatility counterparts, which makes no sense in an efficient market unless you consider two market factors: Individual investors can be irrational, and institutional investors can be handcuffed to benchmarks. The first factor—irrationality—is common knowledge. “Buying a low-priced, volatile stock is like buying a lottery ticket: There is a small chance of its doubling or tripling in value in a short period and a much larger chance of its declining in value,” the paper states, and one need look no further than the recent half-billion dollar Mega Millions lottery hysteria to confirm this fact. But the idea that the apparently rational benchmarking by institutional investors is also warping the market is perhaps less obvious. “Why do institutional investors not at least overweight the low-volatility quintile?” the paper asks. The response: “We believe that the answer involves benchmarking.” The usual asset management/owner equity contract, Baker and the authors believe, “contains an implicit or explicit mandate to maximize the ‘information ratio’ relative to a specific, fixed capitalization-weighted benchmark without using leverage”. They continue: “Although the ultimate investor cares more about total risk than tracking error, it is arguably easier to understand the skill of an investment manager—and the risks taken—by benchmark.”
“To summarize,” it concludes, “the combination of irrational investor demand for high volatility and delegated investment management with fixed benchmarks and no leverage flattens the relationship between risk and return. Indeed, the empirical results suggest that, over the long haul, the risk–return relationship has not merely been flattened but inverted. Yet sophisticated investors are, to a large extent, sidelined by their mandates to maximize active returns subject to benchmark tracking error.” Benchmarking, in effect, is a limit on the ability to arbitrage this persistent anomaly out of existence.
This work emerges from Baker’s larger field of study, behavioral finance, and is a reflection of the current financial ethos: Well, something didn’t work quite the way Milton Friedman said it would. Indeed, the admission that markets are consistently inefficient seems to fly in the face of all that the Chicago School of economic theory stood for. Baker admits as much. “Yes, for sure it flies in the face of that,” he said during our talk. “Of course, their response would be ‘this is a statistical fluke that won’t repeat’, or they’d say we are not measuring risk properly. I think for the low-volatility anomaly, it is challenging, because we’d have to be not only measuring risk wrong, but getting its sign flipped.” Take that, Eugene Fama.
More concretely, Baker’s work highlights another recent revelation in institutional investing—namely, that benchmarks must be rethought. Be it NACUBO figures or transition management pre- and post-trade estimates, benchmarks have come under fire for skewing incentives. It is no different, Baker said, with equity investing. “Investors, be it innate or based on institutional momentum, tend to be tied to benchmarks. Any change would require a change in mindset—a wholesale one that would require them to re-evaluate how they judge an investment manager relative to a benchmark.” Baker—who, admittedly, has a stake in the game, being a consultant with Acadian Asset Management—hopes that his research will help persuade institutions to make this leap.
Be it with equity investing or at a fund level, many investors have recently come to hold this mantra dear: Above all else, don’t lose money. If the benchmark is down 20%, and you’re down 18%, you’ve beaten the benchmark—but you’ve also lost nearly a fifth of your capital and the sponsoring institution will, in all likelihood, suffer accordingly. Thus the rise of strategies such as risk parity, tactical asset allocation strategies, and—with Baker’s help—low-volatility investing, all meant to offer protection against large capital drawdowns. “Those investors who are less benchmark reliant, they’re just more likely to take advantage of this anomaly,” he concluded. “If low-volatility does what we think it will do, they’ll be rewarded for doing so.” Considering his resume, investors should probably listen.