By Nathan Greenwald
The market crash of 2008 made financial advisors and investors more attuned to the downside risk of their investments, leading many folks to seek lower-risk investments that maintain returns. Seems like wishful thinking, considering that conventional investing wisdom holds that return is a function of risk, and that in an efficient market the only way to achieve higher returns is to take on more risk. But new products have hit the scene--buttressed by academic research--that aim to achieve the holy grail of higher returns with less risk. These investments are alternatives to products that assume return is always a function of risk.
So called "low volatility" indices, ETFs, and mutual funds that have recently proliferated are designed to achieve market beating returns by investing in equities with the lowest volatility--typically as measured over the previous year. This approach avoids the high fliers and most volatile stocks in favor of large, stable and often stodgy and unexciting companies which are often concentrated in such industries as utilities, health care, and consumer staples. Does this seemingly paradoxical approach work? And what does it say about the tradeoff between risk and return?
"The idea that high beta stocks in the Capital Asset Pricing Model model were predicted to outperform has been around since the 1950s, but researchers have known for a long time that this is not true," says Morningstar analyst Samuel Lee. He notes that research published in 1972 by Fischer Black, Michael Jensen, and Myron Scholes--the researchers whose option pricing model has become ubiquitous--found that higher beta stocks underperformed lower beta stocks.
Eugene Fama and Kenneth French also acknowledged this contradiction and developed their three-factor model for stock return in the 90s that adds valuation and market capitalization to beta in an attempt to better explain stock returns. More recently, David Blitz and Plim Van Vliet of Robeco published research in 2007 with similar findings.
And a paper by Malcolm Baker, Brendan Bradley and Jeffrey Wurgler provides the most clear cut demonstration of this paradox. They found that between 1968 and 2008, stocks in the lowest quintile of volatility outperformed the market on a risk adjusted basis by 2% a year. They essentially duplicated the market's return while generating 33% less volatility.
Complicating The Risk/Return Equation
Morningstar's Lee believes this paradox does not invalidate the relationship between risk and return--rather, it complicates it. "The low volatility anomaly does not mean low risk means high returns across asset classes," he says. "Within asset classes, the relationship between risk and return can break down at the margin. Extremely high volatility stocks are often outperformed by low volatility stocks. In very specific circumstances risk and return are not related. in truth, most academics have acknowledged that risk and return are not always correlated."
Lee, who is editor-in-chief of Morningstar's ETF Newsletter, is partial to some of the low-cost ETF offerings in the space such as the iShares suite of products based on the MSCI low-volatility indices. One such fund is the domestically-focused iShares MSCI USA Minimum Volatility Index (USMV). It also includes international-focused offerings including the iShares Emerging Market Minimum Volatility Index (EEMV), iShares EAFE Minimum Volatility Index (EFAV) and iShares MSCI All Country World Minimum Volatility Index (ACWV).
Lee also likes the PowerShares funds, whose domestic product--the PowerShares S&P Low Volatility Index (SPLV)--has already attracted $2.4 billion in assets, making it the largest fund in the group of products that Morningstar defines as low volatility products. ETFs from both iShares and PowerShares have expense ratios less than 0.35 %.
The funds from iShares and PowerShares were all launched last year--PowerShares in May and iShares in October. During their short existence, the above-mentioned iShares funds have returned between 10% and 20%, depending on the fund, with USMV the highest returning fund to date. The PowerShares SPLV fund has returned nearly 14%.
The products differ in portfolio construction and sector weighting. "PowerShares uses simple mechanical rules, weighting stocks based on their one-year trailing volatility," Lee says. "The iShares product uses a very sophisticated model which estimates exposure to a number of factors: volatility, valuation, market risk, and sector and country weightings. This approach makes it more representative of large indices but also contains idiosyncratic security selection."
In the actively managed mutual fund space, Lee is intrigued by AQR's offering. AQR is a quantitative fund company that has launched the AQR US Defensive Equity Fund (AUEIX). Lee believes AQR's research in this area is compelling, and believes their recent paper on the subject is likely to become the canonical and most-cited piece on low volatility investing. AQR's paper goes beyond highlighting the low volatility paradox to suggest that Warren Buffett's history of investment outperformance can be explained by his leveraged portfolio of high quality, low volatility stocks. And AQR believes its funds are modeled the same way, although without leverage.