Does more risk assure higher returns?

A basic tenet of modern portfolio theory suggests that investors who take on greater risk can expect a higher return. Under this theory, to maximize your portfolio’s return, you need to accept more volatility. In the past few years there have been several studies completed that suggest a counter theory. These studies make the argument that low volatility investments actually outperform their higher volatility counterparts over the long-term.

One of those studies, published in Financial Analysts Journal, concluded that from 1968 – 2008 lower volatile stocks had a better annualized return than higher-risk stocks. As a result of a number of these studies and the market volatility of the past decade, there are number of low volatility Exchange Traded Funds (ETFs) that were created and according to Morgan Stanly, three of them rank in the top 10 ETFs started in the past year.

As with many investments, the expected results do not always occur in a consistent or predictable fashion and the short-term results can vary from the long-term performance. This issue with short-term performance can be seen with low volatility ETFs to the extent that during strong bull markets they frequently underperform many equity indices. If the stock market was rising 40%, you may only see a 20-30% gain in low volatility ETFs. The long-term performance gains for low volatility ETFs are driven by their performance during down markets where they protect some of the downside risk making it easier to recover losses incurred during a bear market. Since investors are typically invested in equities when they see a positive outlook in the markets, it’s more difficult to mentally approach an equity investment to protect on the downside if they see the upside potential in the riskier investment.

Another reason for short-term variation is that the low volatility market includes sectors which don’t always perform well in certain market environments. With the fear of the Fed easing their monetary policy over the past few weeks, we have seen interest rates on 30-year mortgages and 10-year treasury’s rise. In this rising interest rate environment, higher yielding utility stocks have been hit particularly hard. These stocks account for a large allocation in low-volatility investments and have caused these funds to experience sizable drops because of the recent economic news.

It’s important to remember that when selecting investments for a portfolio that the short-term investment results can vary from long-term expected return. It is also the case that investments such as low volatility funds can be best used in a tactical investment strategy. The best tactical strategy for these funds is to utilize them in a portfolio when there are concerns that a recession may be occurring and remove the position from the portfolio during the recovery stage of a business cycle.