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Investment of the quarter: low-volatility stocks

Low-volatility equity strategies may lack the rock-star appeal of chasing high-volatility stocks, but they look likely to gain more attention after recent market wobbles helped their relative performance in the year-to-date jump ahead of traditional benchmarks.

The $4.6 billion (€3.65 billion) Powershares S&P Low-volatility ETF (SPLV), one of the most widely followed low-volatility funds, shed slightly less than 1% over the month to 20 October, more than 4.6% better than the Standard & Poor’s index. The fund is up 7.5% for the year-to-date, almost 3% better than its benchmark, according to Morningstar data.

The phenomenon raises difficult questions, which go to the heart of equity investing theory: why do investors taking less risk actually get more return?

A low-volatility strategy looks to generate a return like the benchmark but with a significantly reduced risk. It requires fund managers to invest in ‘boring’ stocks, typically rarely in the news, which trade with unusually low beta, a relative measure of volatility and correlation to their index. In short, Facebook, Alibaba and Tesla are out; stocks like Sigma-Aldrich, Clorox and Proctor & Gamble are in.

These types of equities have performed better than indices of large capitalisation stocks for the last two decades, according to a paper by Jason Hsu and Feifei Li, published in the Journal of Index Investing last year.

In the period from July 1991 to December 2012, low-volatility stocks in the US delivered a 10.2% annualised return with volatility of 11.2% for a Sharpe ratio, a measure of return per unit of risk, of 0.64. That compares with 8.7% annualised returns for US large capitalisation equities, with higher volatility (14.9%) and a lower (worse) Sharpe ratio of 0.37. The strategy underperformed in 2013 and in the late 1990s.

So, why do low-volatility stocks generally outperform, and is the phenomenon an enduring one? Eric Falkenstein, an equity portfolio manager at Minetonka, Minnesota-headquartered hedge fund Pine River, says the persistence of low-volatility investment performance stretches back 50 years. He wrote his PhD in economics on the topic at Northwestern University, Illinois, in 1994.
Falkenstein says one reason that low-volatility has beaten high-volatility so often may be related to investors’ attraction to ‘lottery ticket’ stocks. While it is not rational to buy a lottery ticket – the expected return is negative – people still buy them in the hope of a life-changing win. The same may apply to investors in volatile stocks, despite the greater likelihood of disappointment. Low beta stocks tend to be under-represented in portfolios and may provide better returns over the long run.

Falkenstein says this feature of equity markets may also be the final nail in the coffin of the Capital Asset Pricing Model (CAPM). The central point of his argument is that if less volatile stocks generally outperform more volatile stocks then the argument of the model, that more risk equals more return, breaks down.

“The standard CAPM model doesn’t work. There should be a linear relationship between beta and the broad market and return,” he says.

“We haven’t found that data in 50 years of looking. If you’ve spent 50 years looking and still haven’t found it then it doesn’t exist.”

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