Does “Low Risk” Outperform?

A new paper by Robert Haugen, president of research house Haugen Custom Financial Systems, and Nardin Baker, chief strategist, Global Alpha, Guggenheim Partners Asset Management, claims that low risk (really low volatility) stocks consistently delivered market-beating returns in all of the 21 developed countries they studied between 1990 and 2011 (video here). Their research showed the same was true of 12 emerging markets they looked at over a shorter period since 2001. In essence, their idea is that low volatility stocks are boring and underappreciated but outperform because money managers are looking for the big score.

The very first sentence of the paper claims that “The fact that low risk stocks have higher expected returns is a remarkable anomaly in the field of finance.” Obviously, this assertion at least seemingly contradicts a basic premise of economics — that risk and reward are inherently connected.

While their conclusion is not original, the authors are not bashful about trumpeting their assertions. In fact, the paper could not have made its claim much more directly or triumphantly:

“As a result of the mounting body of straightforward evidence produced by us and many serious practitioners, the basic pillar of finance, that greater risk can be expected to produce a greater reward, has fallen.”

The study of  the 12 “observable” emerging markets included analysis of market returns in China, India, Brazil, South Africa, the Philippines and Poland.

But I’m not entirely sold. Here’s why.

1. The first sentence of the paper conflated expected returns with past returns.  That bonds have outperformed stocks over the past 30 years does not mean that bonds have higher expected returns going forward. 

2. Volatility and risk are hardly the same thing (see here and here, for example), so equating “low volatility” with “low risk” is a significant error.

3. If higher risk always led to higher returns, it wouldn’t be higher risk.

4. The referenced time frame is much too small to be conclusive (Antti Ilmanen, managing director of AQR Capital Management and the author of the terrific book, Expected Returns, agrees).

That said, it remains an interesting anomaly well worth exploring, particularly during secular bear markets (as these stocks should handle significant downdrafts better — see below, from Alliance Bernstein). 

However, despite the promise of a low volatility approach, I would focus more on a related category — low beta stocks (see here, here, here, here and here).