Rethinking Risk and Return in Equity Portfolios

In a new paper, “True Grit: The Durable Low Volatility Effect,” analysts from Research Affiliates question the tautology that riskier portfolios have higher expected returns over long-term investment horizons than do low-risk portfolios. It’s a piece of reasoning underlying much of the investment advice given to retirement plan participants: Riskier portfolios may suffer when the markets fall, but in the long run any losses will be more than compensated by the strong growth risky portfolios make possible.

“The theoretical relationship between ex ante risk and expected return is so obviously a truism that it seems silly to write about,” the Research Affiliates paper explains. “But we bring it up here precisely because ‘it goes without saying.’ The statement that one must accept higher risk to earn higher returns is axiomatic. It is, in fact, such a basic proposition that classical and neoclassical finance simply cannot be stretched or twisted to accommodate contrary observations.”

However, the paper argues that as the investment management industry learns more about behavioral finance and becomes more willing to question whether markets truly turn on rational, utility-maximizing behavior, the traditional axioms of risk and return will increasingly come into question.

As Research Affiliates explains, behavioral descriptions of why investors accept higher risk in longer-term portfolios “depend on the observation that many market participants have a clear preference for risky growth stocks.”

“Indeed, their partiality is so strong that, in addition to rejecting value stocks, they often drive the price of growth stocks to unrealistically high levels,” the paper explains. “In other words, many investors tend to shun the stocks that are out of favor—the value stocks in their opportunity set—and overpay for prospective growth.”

The outcome of this behavior is predictable, according to Research Affiliates: Low-priced stocks, which are less volatile, can frequently outperform the more volatile high-priced stocks, even over the long term. Research Affiliates says it has run an extensive economic simulation to test this theory, and the results are encouraging for the low-volatility approach to long-term investing.

For instance, while a simulated cap-weighted benchmark portfolio of U.S. stocks had annualized volatility of 15.45% and annualized returns of 9.81% based on economic data from 1967 to 2012, a theoretical low-volatility strategy showed both lower annualized volatility (12.55%) and higher annualized returns (11.65%). So called “low-beta” portfolios also outperformed traditional index-based approaches, securing 12.84% annualized volatility and 11.83% in annualized returns during the same period.

Strikingly, the Research Affiliates paper shows a similar pattern even for emerging markets. Between 2002 and 2012, the theoretical cap-weighted benchmark global emerging markets portfolio showed 14.59% in annualized returns and 23.83% in annualized volatility. This compares with annualized volatility of about 16.2% for both low volatility and low beta emerging markets portfolios, which both returned more than 21% during the 2002 to 2012 time period.

“The issue, then, is to make sense of a preference that often leads to self-defeating investment decisions,” the paper continues. “A simple, direct explanation of the low volatility effect is that many investors willingly accept lottery-like risk in pursuit of better-than-average returns. In other words, many investors are given to gambling.…Investors with a strong penchant for gambling are likely to choose high-risk stocks with large potential payoffs over low-risk stocks with unexciting expected returns.”

A more subtle behavioral explanation of the preference for risky stocks is grounded in textbook finance, the paper suggests: “Various forms of leverage can boost rates of returns. Many investors, however, are unable or unwilling to use leverage. For example, they may be subject to investment policy guidelines that prohibit borrowing, or they may not have access to low cost credit, or they may balk at the downside risk of a leveraged position.”

In this respect, risky stocks offer an outlet for leverage-constrained or leverage-average investors, including those in retirement plans, who are seeking higher returns. Additionally, institutional portfolio managers are often discouraged from overweighting low volatility stocks by an implicit mandate or explicit contractual requirement to maximize their information ratio relative to a cap-weighted benchmark, according to Research Affiliates.

From the client’s perspective, placing a tolerance range around tracking error facilitates monitoring aggregate asset class risk exposures and evaluating individual managers’ performance, Research Affiliates says. “Unfortunately, however, it also promotes closet indexing,” the paper explains. “And because cap-weighted indices favor the most popular stocks, closet indexing tends to sustain the low volatility effect.”

But can the “low-volatility premium” last if more investors take note? Research Affiliates says the increase in smart beta investing since the global financial crisis of 2008 “tells us that investors can successfully disavow the notion that the only way to get higher returns is to take more risk.” Further, the asset management industry is one fully steeped in tradition—meaning it's unlikely that a wide-scale push towards low volatility investing will dry up the potential premium. 

In closing, the paper explains there will most likely be periods when investors’ demand for low volatility stocks will drive up prices and reduce the return premium to a level that makes the strategy unattractive. Over the long term, however, “it is reasonable to expect low volatility investing to persist in producing excess returns.”

Research Affiliates published the paper, available here, as part of its Fundamentals research series. It was penned by Feifei Li and Philip Lawton.