High-risk, high-return equities have been on a hot streak, outpacing the big, boring dividend payers in the current market rally. However, looking at risk-adjusted returns, low-volatility stock exchange traded funds could outperform in the long run.
“In nearly every market studied, low-volatility stocks have greatly outperformed high-volatility stocks on a risk-adjusted basis, a finding at odds with many investors’ notions of risk and return,” writes ETF strategist Samuel Lee for Morningstar.
Lee explains that there are three reasons why low volatile stocks have historically outperformed: leverage aversion – investors don’t want to use volatile stocks to hit their expected-return targets; high-volatility stocks are overpriced by investors seeking “lottery tickets” to win it big; asset managers steer toward high-volatility stocks with poor risk-adjusted returns. [Low-Volatility ETF Cools as ‘Junk’ Stocks Soar]
While most analysts point to the S&P 500’s cheap 15 forward price-to-earnings ratio or a forward earnings yield just under 7%, these values are based on the short-term. In utilizing the Shiller P/E, which averages real earnings over 10 years, a 1,600 S&P 500 equates to a Shiller P/E of 23, or 40% higher than its historical average.
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