Investors and markets were on edge all year. To judge by Treasury prices, one might never suspect the U.S. had spent another year borrowing money that under plausible scenarios it would not be able to repay. Actually, Treasuries rose from already dizzying heights for two reasons. Nearly all the allegedly sovereign alternatives were even less attractive. And the Fed once again worked overtime to create the appearance of an alternate reality in which the U.S. government was not poised at the edge of a fiscal abyss.

Share prices might have suggested a calm but enthusiastic investor base; in reality institutional investors were making multi-generational lows for the percentage of their assets held in U.S. stocks. Measured purely against earnings, stocks were reasonably priced. Measured against discount rates, i.e., against the paltry competition from bond yields, stocks were cheap. And yet not only institutional but retail investors continued to prefer fixed income.

Retail investors seemed infatuated with high yield bonds and drove explosive growth in high yield ETFs creating a noticeable bifurcation in the high yield market. Large liquid issues of the sort ETF managers are allowed to buy pushed the yield on the Merrill Lynch High Yield Index down to a laughable 5.5%, while smaller, less liquid issues remained in the double-digits where dubious credits belong. Clearly, retail bond investors were not driven primarily by yield, or even the prospect of total return. (Who would have bet on prices going yet higher?) They were driven by fear.

Bond markets were overbought from top to bottom, not because the U.S. was fiscally healthy and not because the stock market did not offer attractive returns, but because investors, still traumatized by 2008 and the ongoing travails of Europe, valued what appeared to be security over yield.

For several years now the market has been saying it would rather bleed out slowly by investing in bonds with negative real yields than undergo a perhaps fatal electric shock as a result of investing in the real economy. Through this entire period, markets have been so transfixed by fears of collapse in equity markets they have steadfastly ignored the risks of overbought credit markets.

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The math behind the construction of the VRP is highly technical, but in brief, the authors start by working under the assumption that they can estimate the VRP for a security from observed high-frequency intraday stock price returns and the prices of listed options. Based on a small-scale Monte Carlo experiment, they determined that a five-minute sample period for security prices in each month should be adequate for their purposes. They then applied their analysis to the S&P 500 and found that the estimate of a constant volatility risk from the basic dataset was statistically significant. They then created an enhanced estimator of a time-varying volatility risk premium by extending the dataset to include a number of macro-finance variables, including realized volatility, Moody’s AAA bond spread, housing starts, P/E ratio, industrial production, producer price index (PPI), and payroll employment.

The authors also used the index to predict stock market returns and find it has twice the predictive power of the best macro-finance variable (P/E ratio) and far outperforms industrial production, non-farm payrolls, and dividend yield (though some macro-finance variables are already incorporated in the volatility premium).

This paper was a finalist for the 2011 Whitebox Prize for the best financial research of 2011. To see the top 10, click here.

Each methodology was backtested with two sets of stocks: the largest 1,000 U.S. stocks from 1964­–2009 and the largest non-U.S. stocks from 1987–2009. The authors used a wide variety of metrics in their analysis, including total return, volatility, Sharpe ratio, tracking error, and more.

The authors find empirically that these alternative strategies often outperformed standard benchmarks due to exposure to value and size factors. They caution investors to be aware of transaction costs and suggest it might benefit investors to combine less costly alternative strategies to mitigate exposure, rather than investing in a single fund using a method with higher costs that could diminish return.

This paper was a finalist for the 2011 Whitebox Prize for the best financial research of 2011. To see the top 10, click here.