In what has become known as the “low-volatility anomaly,” several studies have shown that low-volatility stocks – those with less price variability than the average stock in the market – deliver higher returns over long periods.
This is often surprising to clients because they’ve long been told that improved returns are available only if they’re willing to shoulder more risk. But, when looking at alpha (not so much a higher absolute return, but a better risk-adjusted one), the data suggest otherwise.
According to a recent Journal of Portfolio Management paper by Feifei Li, head of research with Newport Beach, Calif.-based Research Affiliates LLC, low-volatility portfolios outperformed a capitalization-weighted U.S. stock portfolio by roughly 1.8% a year between 1967 and 2012 while exhibiting 25% less annual volatility.
The appeal of low-volatility investing isn’t necessarily that advisors are able to unearth undervalued securities for clients; it’s that low-volatility stocks are more likely to help you steer clear of the types of stocks that tend to become particularly overvalued.
Because the average holding period of stocks is relatively short, the prices of the most popular stocks often are a function of how well a company has captured investors’ imagination rather than the firm’s underlying fundamentals.
Sell-side analysts also tend to inflate earnings growth forecasts for more volatile stocks, especially if they have positive information about them, Li’s paper notes. Given that investors typically overreact to analysts’ forecasts, this bias contributes to the market overvaluing high-volatility stocks, thereby lowering their returns.
Money flowing into benchmark-driven strategies, such as index funds, further distorts the market and also can favour low- volatility stocks.
Reducing risk by steering clear or selling higher-volatility stocks and shifting into low-volatility choices thus may offer your clients greater freedom to increase the equities portion of their portfolios without necessarily taking on a great deal more risk. However, as you introduce the notion of accepting a different long-run ratio of return to risk, you need to prepare for periodic underperformance and client disappointment.
Of course, the problem with investment anomalies is that once identified, they tend to disappear quickly. Continued interest in volatility-sensitive strategies has led to increased demand for low-volatility stocks, and conceivably could eradicate the return premium altogether.
Writing recently in the Financial Analysts Journal, a group of researchers studied stock data dating back to 1963 and found that although low-volatility stocks tend to do well in recessions, these stocks generally underperform as markets recover. In fact, in recent years, such lower-risk stocks actually have traded at a premium, according to the study – the opposite of what they’ve been doing for most of the past three decades.
The paper adds that the required rebalancing and increased trading of stocks that often are less liquid imposes costs that eat up most of the premium available.
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