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Does Lower Risk Mean Higher Returns?

Not all risk is rewarded in a low-return world. Consider these ETFs.

Samuel Lee, ETF Analyst, 06/28/2011

Many investors have been making up for low yields by taking on more risk, whether it's by dipping into lower-quality bonds or holding more dividend-paying stocks. Exchange-traded fund sponsors have been busy launching products touting even higher payouts or more-exotic asset classes, including obscure oddities such as master limited partnerships, business-development companies, and bank loans. By seeking higher yields and greater risk, investors are likely setting themselves up for lower risk-adjusted returns and possibly worse absolute returns than if they had stood pat. Blame the strange relationship between risk and return.

High Volatility, Low Returns
Researchers have discovered a kink in the traditional risk-reward relationship. Professors Andrew Ang, Robert Hodrick, Yuhang Xing, and Xiaoyan Zhang discovered that the most volatile stocks have underperformed the least volatile stocks globally, both on absolute and risk-adjusted bases. The effect can't be explained by known risk factors such as size, value, momentum, and liquidity. Similarly, in the past four decades, the most distressed (and therefore most volatile) bonds have either lost money or underperformed investment-grade bonds on an absolute basis.

Who are these investors gleefully torching their money? Some blame investors who crave lottery-like securities, which, over the long run, lose money but have a small chance of paying out big. Others focus on wildly overoptimistic investors who push up the price of stocks that are hard to value--the winner's curse writ large. Investors should be careful when dipping their toes into the riskiest segment of any asset class, as they usually offer low risk-adjusted returns. An elegant model proposed by two researchers may tell us why.


Betting Against Beta
AQR researchers Andrea Frazzini and Lasse H. Pedersen argue that investors target returns, but either can't or won't use leverage to achieve them. Instead, they stretch out on the risk spectrum, taking on assets with lower credit quality, longer duration (a measure of interest-rate sensitivity), or more economic sensitivity. In other words, they shoulder more "beta," or marketwide systemic risk. By doing so, investors inflate the price of high-beta securities and subsequently realize poor risk-adjusted returns. Frazzini and Pedersen document inferior risk-adjusted returns in high-beta securities in almost every major asset class. The poor returns of junk bonds are especially striking. The Sharpe ratio (excess return divided by standard deviation of returns) of bonds rated AAA was 0.87; distressed bonds lost money and were extremely volatile, to boot.


In fact, high-beta assets have been so richly priced that a portfolio holding low-beta stocks and shorting high-beta stocks has produced excellent returns. They dub this factor Betting Against Beta. There's little doubt that AQR and other hedge funds are exploiting this phenomenon. While they may be selling high-beta assets, their capital is too small to fully price away the strategy--not that they would want to.

The High-Risk Trap
An implication of Frazzini and Pedersen's model is that investors reaching for yield in a low-interest environment may be setting themselves up for disappointment. When investors decide that current yields aren't good enough, they start adding riskier assets to their portfolios. Their collective shift reduces the expected return of high-beta securities; the old calculus of high risk, high reward becomes one of higher risk, low reward.

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