Does “Low Risk” Outperform?

Guest post by Contributing Editor, Robert P. Seawright, Chief Investment and Information Officer for Madison Avenue Securities.

A new paper by Robert Haugen, president of research house Haugen Custom Financial Systems, and Nardin Baker, chief strategist, Global Alpha, Guggenheim Partners Asset Management, claims that low risk (really low volatility) stocks consistently delivered market-beating returns in all of the 21 developed countries they studied between 1990 and 2011 (video here). Their research showed the same was true of 12 emerging markets they looked at over a shorter period since 2001. In essence, their idea is that low volatility stocks are boring and underappreciated but outperform because money managers are looking for the big score.

The very first sentence of the paper claims that “The fact that low risk stocks have higher expected returns is a remarkable anomaly in the field of finance.” Obviously, this assertion at least seemingly contradicts a basic premise of economics — that risk and reward are inherently connected.

While their conclusion is not original, the authors are not bashful about trumpeting their assertions. In fact, the paper could not have made its claim much more directly or triumphantly:

“As a result of the mounting body of straightforward evidence produced by us and many serious practitioners, the basic pillar of finance, that greater risk can be expected to produce a greater reward, has fallen.”

The study of  the 12 “observable” emerging markets included analysis of market returns in China, India, Brazil, South Africa, the Philippines and Poland.

But I’m not entirely sold. Here’s why.

  1. The first sentence of the paper conflated expected returns with past returns. That bonds have outperformed stocks over the past 30 years does not mean that bonds have higher expected returns going forward.
  2. Volatility and risk are hardly the same thing (see here and here, for example), so equating “low volatility” with “low risk” is a significant error.
  3.  If higher risk always led to higher returns, it wouldn’t be higher risk.
  4. The referenced time frame is much too small to be conclusive (Antti Ilmanen, managing director of AQR Capital Management and the author of the terrific book, Expected Returns, agrees).

That said, it remains an interesting anomaly well worth exploring, particularly during secular bear markets (as these stocks should handle significant downdrafts better — see below, from Alliance Bernstein).

However, despite the promise of a low volatility approach, I would focus more on a related category — low beta stocks. For reference, here are some interesting articles by Geoff Considine:

Other low beta articles you may want to read, include:
Benchmarks as Limits to Arbitrage: Understanding the Low-Volatility Anomaly, written by Malcolm Baker, Brendan Bradley and Jeffrey Wurgler (The Financial Analysts Journal, Jan/Feb 2011) as well as my own May 6th blog post from the CFA Conference focusing on James Montier (see:  CFA Conference James Montier).

About Robert Seawright and the Above the Market Blog:

Above the Market is the blog of Robert P. Seawright, the Chief Investment & Information Officer for Madison Avenue Securities, a broker-dealer and investment advisory firm headquartered in San Diego, California. Its focus is the capital markets, economics and personal finance from a data-driven perspective. His About Me profile is available here.

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The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Madison Avenue Securities is not affiliated with FOLIOfn or The Portfolioist.

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2 thoughts on “Does “Low Risk” Outperform?

  1. jack

    Bigger max drawdowns and longer periods of time in drawdown to new equity highs are the main reasons why most people jump ship and look for greener grass. Call those human measurements of risk, volatility , and reward. If that were not true, there would not be 10000 internet sites promoting some new way to beat the market. A The best thing one can do is find a plan……..for me that means giving up some gain for smaller and shorter times underwater, and then sticking with it. Easy to say you can handle a 20% drawdown, until you are in it with your real money. Let alone a 50% drawdown. Like a couple times in the past decade alone.
    The best thing one can do when evaluating a plan someone is trying to sell you on is to simulate that plan in the drivers seat. Excel is good for that.
    If they show you that from point A to point B your compounded returns over 15-20 years was 12%…….take a hard look at what happened between in getting from from A to B. For instance, was there a point where you were 20% in the hole for 2 years? That might be one scenario where you just could not stomach it any more and you are off to finding the next best plan. If this were not true, those 10000 internet sites trying to promote a new and better plan would be out of business.

    And one more thing while I am on my soapbox. America loves bubbles. In the past decade we had the Internet bubble burst and then the housing bubble burst.
    We got one going now in the bond market. Bonds have been in a bull market since 1982. Well before the big bond funds like Pimco’s were around.
    When the bond bubble bursts, it is going to really hurt those that “think” they are living on fixed income. If you have bonds in your portfolio (which I do), better figure out what your escape plan will be. Or, get familiar with some of the hedging funds for rate hikes. The 10 year T Note is at 1.78%. Some say the floor is at 1.5. Whatever it is, it is not that far down to 0. It will be ugly one day for sure.

  2. Pingback: The Case for Dividend-Focused Investing « Portfolio Investing Blog: Portfolioist

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