Much to the active investor’s chagrin, the least risky stocks on the market tend to outperform riskier picks. Consequently, investors may be better off sticking to a low-volatility index-based exchange traded fund.
From 1970 to 2011, fund manager GMO found that the top 25% of U.S. stocks with the highest sensitivity to the market generated an average annual return of 7.2% at double the risk of the 25% of stocks with the lowest sensitivity to the market, which generated an annual return of 10.6%, reports John Authers for the Wall Street Journal.
Across global equities, the least market sensitive stocks averaged a 10.1% return since 1984, compared to a 4.1% return for the most market sensitive. [The Advantages of Steady Low Volatility ETFs]
ETF investors can also target the low volatility portion of the U.S. equities market through the PowerShares S&P 500 Low Volatility Portfolio (NYSEArca: SPLV), and iShares MSCI USA Minimum Volatility ETF (NYSEArca: USMV). SPLV takes the 100 least volatile stocks from the S&P 500 while USMV takes into account variance, correlation and sensitivities to risk factors. Year-to-date, SPLV is up 12.8% and USMV is 12.6% higher, whereas the S&P 500 index increased 10.4%. [Minimum Volatility ETFs Strut Their Stuff in October]
Investors can also track global low-volatility stocks with ETF offerings like the iShares MSCI All Country World Minimum Volatility ETF (NYSEArca: ACWV), which takes about 300 of the least volatile stocks from the parent MSCI All Country World Index. ACWV has increased 9.6% year-to-date, whereas the iShares MSCI ACWI ETF (NasdaqGM: ACWI) gained 4.0%.
Additionally, the iShares MSCI Emerging Markets Minimum Volatility ETF (NYSEArca: EEMV) takes about 200 of the least volatile picks from the MSCI Emerging Markets Index. EEMV is up 4.6% year-to-date while the iShares MSCI Emerging Markets ETF (NYSEArca: EEM) is 0.9% higher.
Some argue that the increased practice for active managers to measure performance against a benchmark has fueled the distortion between low volatility and riskier stocks, which has created the so-called risk-return anomaly.
“This makes managers unwilling to deviate from the index and exacerbates price distortions. Because trading against overvaluation exposes managers to greater risk of deviating from the index than trading against undervaluation, agency frictions bias the aggregate market upwards. They can also generate a negative relationship between risk and return because they raise the volatility of overvalued assets,” according to a research paper by Paul Woolley and Dmitri Vayanos of the London School of Economics and Andrea Buffa of Boston University.
Paul Woolley and Dmitri Vayanos of the London School of Economics and Andrea Buffa of Boston University point out that the disparity between low-volatility and risky stocks appears when active managers underweight positions in stocks with large weights in an underlying index and volatile prices. If a stock doubles in price while the investor is half-weight, the disparity compared to the index doubles, whereas if the manager is double-weighted and the price halves, the mismatch is also halved. Consequently, active managers have an incentive to overweight large and risky securities.
For more information on low-vol stocks, visit our low-volatility category.
Max Chen contributed to this article.