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, hereherehere and here).

12 thoughts on “Does “Low Risk” Outperform?

  1. Why not just put a sensible amount of your portfolio in a guaranteed-principal annuity with returns tied to a stock (or bond) index? Who wants to be the guy or gal needing funds when all of their traditional hedges have failed to perform as planned? And please don’t tell me indexed annuities are “too complex”. No one who had just read this article could fail to sense the irony in such a comment.

  2. Bob, I think you hit a major chord with your correct assessment that risk and volatility are vastly different. Any study of the investment strategies employed by the Yale and Cornell endowment funds offer substantial evidence that higher risk investments have outperformed equities over the last 30 years as well. These “Endowment Models” have utilized many higher risk investments like private equity, private debt, real estate, absolute return strategies and commodities to successfully achieve a higher return.

    So any assertion that lower risk has outperformed higher risk over the last 30 years seems a bit misguided, as evidenced by the endowment returns with substantial risk. The truth is that domestic equities have just underperformed their expected returns while bonds have prospered from a decreasing interest rate environment. Nobel Prize winner and Wharton professor Jeremy Siegel has publicly warned bond investors that they may be nearing the top of a bond bubble. If his assertions prove correct and interest rate increases hurt bond performance, there may not be much of a future argument for Haugen and his associates.

    • While I think you make a terrific point, Jon, I should add a bit of clarification. The products used by endowments are so much different from what individuals can get as to make comparisons highly problematic. As Yale’s David Swensen emphasizes, access is crucial and Yale has access that individuals do not. Moreover, I don’t read the paper’s claim so broadly as to assert that low risk beats high risk generically and overall. But the anomaly is quite remarkable nonetheless. Finally, Prof. Siegel has won a number of major awards, but the Nobel Prize is not among them.

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