Got a need for speed? Be careful around the stock market's curves

Lesser-known, low-volatility shares typically beat their highly popular, more volatile peers.

  • By Mark Hulbert,
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Low-volatility stocks have passed yet another test. And it was a big one: Did a portfolio of previously low-volatility stocks protect investors from a significant chunk of the market's turmoil earlier this year?

You be the judge. So far this year, the iShares Edge MSCI Minimum Volatility USA ETF (USMV) has experienced 37% less daily volatility than the S&P 500 (.SPX) (as judged by the variance of daily returns). That's right in line with what we'd expect, given this ETF's beta of 0.66.

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In return for saving investors from much of the market's volatility, furthermore, this ETF paid a relatively small price: Its year-to-date gain, according to FactSet, is 4.5%, versus 5.7% for the SPDR S&P 500 ETF (SPY).

The question that this year-to-date experience in effect poses for investors: Are you willing to give up a small price — in this case 1.2 percentage points over a six-month period — in order to reduce your portfolio's volatility by a third?

Consider that low-volatility stocks typically also perform admirably in bull markets, lagging the market indices by only a modest margin. As a result, over a full market cycle that includes both bull and bear markets, low volatility stocks historically have performed just as well as the overall market (if not better) with significantly less volatility.

That's a winning combination.

Over the last five years, for example, according to investment researcher Morningstar, the iShares Edge MSCI Minimum Volatility USA ETF has produced a 12.3% annualized return, versus 12.9% annualized for the S&P 500. That's a small price for reducing risk by a third, according to the Capital Assets Pricing Model, the standard theoretical model for understanding the relationship between risk and return. As a result, the iShares ETF significantly outperforms the S&P 500 on a risk-adjusted basis.

Another way of appreciating low-volatility stocks' investment rationale is the percentage of up and down markets that they "capture." According to Morningstar, the iShares Edge ETF over the last five years has "captured" 82% of the S&P 500's upside, versus only 62% of the market's downside.

Not a bad trade-off.

To be sure, low-volatility stocks in recent years haven't fully lived up to historical precedents. According to a study by the late Robert Haugen and Nardin Baker, a portfolio that held the 10% of stocks with lowest historical volatilities did 18% per year better between 1990 and 2011, on average, than the decile containing the most volatile stocks. This result reflected average performance not just in the U.S. market but in 32 foreign countries' markets as well.

But keep in mind that the market over the last several years has been dramatically less volatile than usual. The low-volatility-stock approach wouldn't be expected to live up to historical expectations in such an environment. In any case, it's worth emphasizing, the approach's recent performance is still compelling on a risk-adjusted basis, even if it hasn't matched previous decades.

Why would a low-volatility strategy perform as well as it does? Human psychology appears to be a major factor: We naturally pay the greatest attention to the stocks that are the most volatile. But as a consequence of this greater attention, Baker has explained to me over the years, "we tend to overpay for the most volatile stocks" — which, in turn, means that such stocks tend to be below-average subsequent performers.

Baker and Haugen documented this by correlating the performance of a stock with the number of stories about it that had previously appeared on Dow Jones News Wires. They found a highly significant inverse correlation: The most volatile stocks by far had the most stories written about them and delivered the lowest subsequent returns.

In contrast, the least volatile stocks are boring — so much so that few journalists bother to cover them and few, if any, Wall Street analysts follow them.

The particular metric that Haugen and Baker used to identify low-volatility stocks was the standard deviation of monthly returns over the trailing 24 months. Below are those least-volatile stocks as of the end of June that are also recommended for purchase by at least one of the investment newsletters I monitor:

  • Aflac (AFL)
  • Amdocs (DOX)
  • BCE (BCE)
  • Coca Cola (KO)
  • Toronto-Dominion Bank (TD)

A quick check of new stories about these stocks provides evidence that is consistent with Haugen's and Baker's findings. On the MarketWatch website, for example, the most "recent" news story focused on Amdocs was 2½ years ago; for BCE it was 18 months ago.

The question to ask yourself is whether you're willing to invest in boring stocks in order to produce decent and steady returns over the long term. Many of you, if you're honest, will have to admit that you crave more excitement. There's no shame in that concession. Just realize that you'll probably pay a price to satisfy your craving.

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