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Many investors love the thrill of finding the next "glamour" stock, and who can blame them? It's human nature to want the shiny new thing. Wall Street pushes these stocks by promising big returns, and the financial media cover them like Hollywood glitterati.
The catch? If you're in the market for the long haul, you should fight the urge to buy them. That's the conclusion of several recent studies showing long-term investors are better off sticking with lower-risk stocks and avoiding riskier ones.
"We're all taught in investing classes that you get rewarded for taking risk," says Nardin Baker, chief strategist, global quantitative equity strategies at Guggenheim Partners Investment Management in Boston and co-author of a recent study on the subject. "That may be true when comparing stocks to bonds. But in the stock market it's not true."
Volatility makes many investors nervous and has kept millions of them out of the market even as stocks have moved higher. Yet research since the 1970s shows that low-volatility stocks match or beat the market's returns, with about a third less risk. The phenomenon has persisted in the markets since the 1920s and it's been dubbed the "low risk anomaly" because it seems to contradict a key tenet of financial theory: that you have to take more risk to earn higher returns.
Yet while the strategy is well-known, some research suggests it may still be effective — offering a way to get equity-like returns with a lot less risk.
The past few decades have included a tech bubble, a housing bubble and two of the worst market crashes in history. But if you had avoided the most volatile stocks you would have fared relatively well, according to a 2012 study by Baker and the late Bob Haugen, a former finance professor at the University of California, who pioneered research on low-risk stocks in the 1970s. (Haugen also launched a website, lowvolatilitystocks.com, which includes a subscription service for investors.)
Studying global stock returns from 1990 through 2011, the researchers found that stocks ranked in the lowest 10% for risk gained an average 7.7% a year, while the riskiest 10% of stocks lost an average 11.7%. The least risky stocks beat the riskiest ones in every global region, including the U.S., Europe and emerging markets. And the gap persisted across nearly all "rolling" three-year periods.
To measure volatility, Baker and Haugen ranked stocks according to their "standard deviation," which measures how much a stock fluctuates. The lower the volatility, the less risky a stock because the price is more stable.
Over longer periods, the performance gap appears to widen even further. A 2010 study co-authored by Harvard finance professor Malcolm Baker, for instance, found that a dollar invested in the market's least risky stocks in 1968 would have grown to $10.12 by 2009, adjusted for inflation. As for a dollar in the riskiest stocks? It would have dwindled to less than 10 cents.
"Over the last four decades the investor who aggressively pursued high volatility stocks would have borne almost a total loss in real terms," the researchers wrote.
One conundrum is why investors would keep buying risky stocks given their low chances of success. The market is supposed to be "efficient," according to financial theory, and the strong performance of lower-risk stocks should presumably disappear over time: Rational investors should snap up the sleepier stocks, while avoiding riskier names or betting against them, eroding the return advantage of low-risk stocks.
Why that hasn't happened is something of a mystery, though there are some hypotheses.
One explanation is the "lottery ticket" effect, says Guggenheim's Baker. Behavioral finance studies suggest investors are constantly searching for the next hot growth stock: the seedling that blooms into the next Apple (AAPL). People chase these stocks for the same reasons they buy lottery tickets or go sky-diving: It's exciting.
Some of these stocks do turn into winning lottery tickets, as early Apple investors know. Yet research suggests that the odds of consistently identifying those stocks through skill, rather than luck, holding them through their winning streak, and then locking in gains, are low.
The main problem is that investors become so excited about these companies, they tend to bid up the prices beyond what's justified by their growth, Baker says. When these companies fall short of expectations — even if only slightly — their stocks tend to dive. And they go through cycles of euphoria and despair, making it tougher to pick the best entry and exit points.
"People overpay for lottery tickets, and risky stocks are like exciting lottery tickets," he says. "If you think of investing not as entertainment but as earning more returns on your money, then high-volatility stocks are on average a poor investment."
Professional stock pickers gravitate to riskier stocks too, though for different reasons. Many pros are paid to beat a benchmark index, which usually involves tilting their portfolios to higher-risk names. If they do outperform, they're likely to attract more money to their funds, especially in a rising market where the riskiest stocks fare best, according to research by Jason Karceski, a former associate finance professor at the University of Florida.
One way the market might adjust is if more investors bet against riskier stocks, or used borrowed money to buy more lower-risk names, says Andrea Frazzini, a former associate finance professor at the University of Chicago, now with investment firm AQR in Greenwich, Conn. Yet many funds aren't allowed to use much leverage and have limits on their ability to sell stocks "short." Using leverage and shorting stocks add costs too, reducing the returns of the strategy, and may be too risky for most individual investors.
"The point is that risk isn't properly priced in the market," says Ronen Israel, a portfolio manager with AQR.
Volatility isn't the only way to measure risk, of course. The market is full of sleepy stocks that languish due to management blunders, declining profits and other factors.
Lower-volatility stocks don't always outperform either. Many can be found in "defensive" sectors such as consumer staples and utilities, which can lag faster-growth areas in a rising market, notes David Blitz, head of quantitative research at Robeco, an investment firm in the Netherlands that manages low-volatility funds.
Still, lower-risk stocks are less volatile for good reason: They tend to be larger companies with more stable earnings and business models that generate strong sales growth relative to their assets, says Guggenheim's Baker. They generally return more cash to shareholders through dividend payments. And their stock prices don't churn as much, reflecting their more stable characteristics.
If all this sounds familiar it's because these are the kinds of companies Warren Buffett has championed for years: quality, established businesses that make everyday products and services.
That "quality bias" helps these stocks hold up better during a market downturn too, according to research from Alliance Bernstein. And bear market resilience is a key ingredient of higher returns. Lose 50% in a stock and you need a 100% return just to get back to even, whereas a stock that loses 10% only needs to gain around 11% to recover fully. Throw in dividend income and these lower-risk stocks may compound much higher returns over a decade or two, especially if the period includes some steep market downturns, says AQR's Israel.
Several low-volatility ETFs and funds are on the market, offering exposure to the strategy. Keep in mind, these investments aren't guaranteed to match or exceed the market's returns, and they may trail the market for lengthy periods. You should do your own research or consult an adviser before investing.
PowerShares now offers five low-volatility ETFs, including the largest on the market by asset size: the S&P 500 Low Volatility Portfolio ETF (SPLV). This ETF tracks an index of the 100 least volatile stocks in the S&P 500 (.SPX) over the past 12 months, providing an efficient, low-cost way to tap the strategy, says Morningstar analyst Samuel Lee.
One risk: It holds about 58% of its assets in utilities and consumer staples — far more than the S&P 500. It also uses trailing measures of volatility rather than forward-looking metrics, making it potentially less efficient.
Two other ETFs to consider: the iShares MSCI USA Minimum Volatility Index Fund (USMV) and iShares MSCI All Country World Minimum Volatility Index Fund (ACWV).
|Fund Name||1-Year Return||30-Day Yield||Expense Ratio|
|PowerShares S&P 500 Low Volatility Portfolio ETF (SPLV)||17.2%||3.0%||0.25%|
|iShares MSCI USA Minimum Volatility Index Fund (USMV)||15.6||2.5||0.15|
|iShares MSCI All Country World Minimum Volatility Index Fund (ACWV)||12.8||2.8||0.20|
|AQR U.S. Defensive Equity Fund (AUENX)||7.9||N/A||1.00|
The first tracks a low-volatility subset of the broad U.S. market, while the second goes global, holding about half its assets in foreign markets. Both are more even keeled: Financials, consumer staples and health care account for no more than about 18% of assets in each ETF. And they're both more stable than their benchmarks with about 50-70% of the market risk, according to iShares.
The downside: The global ETF poses some currency risk due to its foreign market exposure. And both ETFs could lag the market if sectors such as financials and health care fare poorly.
Among mutual funds, one option to consider is AQR U.S. Defensive Equity Fund (AUENX), according to Morningstar's Lee. The fund holds large-cap stocks screened for "quality" attributes like profitability and earnings volatility, and it aims to match or beat the market's returns with about a third less risk, says Frazzini, co-manager of the fund.
The managers also keep the fund from investing too heavily in any one industry, and they make sure the portfolio isn't tilted to growth or value stocks. Those factors can add unwanted risks, says Frazzini, and avoiding them helps keep the fund focused on its core, low-volatility strategy.
One caveat: The fund doesn't have a long track record. It launched last July and has returned 10.4% since inception, compared to a 14.4% gain for the Russell 1000 index (.RUI).
Still, AQR has used the strategy for years with its institutional clients, notes Lee. The firm is well known for its hedge funds and has a strong bench of managers grounded in academic research.
Given its defensive positioning, investors should expect the fund to lag during strong market rallies, says AQR's Israel. When the markets fall, though, the fund is likely to fare better, making up the difference. "The strategy should keep up with the market over time and do so with lower risk," he says.
Daren Fonda is Senior Writer and Investing Columnist with Fidelity Interactive Content Services, a provider of objective investing content on Fidelity.com. He does not own any of the securities mentioned in this article.
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