Mon, 7 May 2012
Recent research suggests that lower-volatility stocks and funds tend to perform better over the course of many years.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com.
Investors have had to endure substantial volatility so far in 2012, and that extends to mutual fund investors as well.
Here to discuss some recent research from our mutual funds team is Shannon Zimmerman. He is associate director of fund analysis for Morningstar.
Shannon, thank you so much for being here.
Shannon Zimmerman: Thanks as always for having me, Christine.
Benz: Shannon, I want to home in on some research that you recently did, where you looked at low volatility investments. Historically, investors have thought that if they take on higher volatility they'll be able to earn a higher return. Your research shows kind of the opposite. So, let's talk about the study.
Zimmerman: That's true. It does turn out to be the case that over the course of many decades--and sort of building on some research that has been done into individual equities that are rolled up into portfolios--it turns out that less risk, if you define risk as volatility, actually leads to more rewards. There is a low volatility premium akin to the small-cap premium or the value premium that investors are more widely aware of.
It sort of flies in the face of what people believe, and it seems counterintuitive. Seemingly, the more risk you take on, the greater the potential reward, and there is a way in which that's true: The more money you put at stake, if the investment works out, the more you'll earn. But if you define risk as volatility--and typically academic researchers are defining it in terms of standard deviation or beta--if you look at risk through those lenses, it turns out that the lower beta, the lower standard deviation investments, tend to perform better over the course of many years.
Benz: So, how time period dependent is this? You mentioned that this a multi-decade set of research, but we have had a couple of bear markets in the past decade or almost the past decade, so how influenced is the data set by what we've had over the past 10-12 years?
Zimmerman: It was excellent point. ... Even though the most recent study appeared at the end of 2011--and I'll come in just a minute to what I have done on the mutual fund side--but in 2011 this paper appeared that looked over the course of 40 years. Now, over the last decade, we've had two major bear markets, two collapses. So, you would anticipate that lower volatility vehicles would do better. But, if it sustained for 40 years, then that's a little bit of a different story.
Your question about time-period specific, though, goes beyond the bounds of just what's happened over the past decade. I mentioned earlier the small-cap premium and the value premium that investors are probably familiar with. Jack Bogle, I think it was was in 2002, came and gave a fantastic keynote address at the Morningstar Investment Conference, called "The Telltale Chart," where he showed that the seeming advantage that small caps and value stocks have relative to growthier fare and larger-cap stocks really owes to very tiny slivers of a very lengthy time series. You remove a few dozen years and basically all that premium goes away.
Every academic study into finance has this potential risk. You go looking for a signal, and lo and behold, you find it, but what are you not seeing because you're not looking? So, I think that Bogle did a nice job of showing really what's being covered over in the small-cap and value premium that people have a lot of confidence in is mean reversion. And so if you're not looking for that, you don't find it.
Similarly, it's probably a lot that's being covered up in this work as well--the academic researchers aren't finding them because they are not looking.
Benz: So, let's talk about the research that you did, Shannon, where you looked specifically at mutual funds. You looked mainly over the past decade, and you examined that correlation between lower volatility/risk and subsequent returns. What did you find?
Zimmerman: I'm always very interested in our proprietary metrics--to see how much they align with what academic researchers are finding using beta and standard deviation. Now, for us, the data set is much smaller. I ran a study that substituted for beta Morningstar risk, which is a gauge of volatility that penalizes funds for poor downside performance. So, if a fund has a bouncier ride when it's losing money, it gets a lower Morningstar risk score.
So, what I found was consistent with what the academic researchers are finding over a longer period of time using beta and standard deviation--and that is that there does seem to be a low volatility premium when you substitute Morningstar risk for beta. It was most observable--and it stands to reason that it would be--when I divided the funds (there were about 1,700 funds I looked at) and the top quartile of those funds fairly substantially outperformed the bottom quartile. In the middle--the second and third quartiles--was kind of negligible, the difference there. But at the extremes, it was meaningful.
Benz: So, top quartile in terms of having the lowest Morningstar risks scores?
Zimmerman: Exactly right. The top quartile would be the least risky funds.
Benz: So, I guess another feather in the cap of low-volatility strategies is that we know from our investor return data, where we look at dollar-weighted investor behavior, we see that investors usually manage better and have better outcomes, better take-home returns, with lower-volatility products than they do with higher-volatility ones.
Zimmerman: It's an excellent point. So, if the academic research is sort of confirming something that we already know to be the case in terms of how investors use funds, then that's a good thing. So, it turns out that investors use low-volatility funds better because they ... don't get the willies when the quarterly report comes, and they haven't gone ... down 15% ... in a flat market. The smoother a ride a fund can give a shareholder, the better they tend to use it. When you look at total returns, which is what the fund has delivered over the trailing periods, versus investor returns, or dollar-weighted returns, that track the money flows into and out.
If it turns out to be the case that in addition to investors using those kinds of funds better than more-volatile funds and ... they are going to be availing themselves of what the academic researchers are finding to be a low-volatility premium, that's a good thing.
Benz: So, there have been some ETFs that have cropped up to capitalize on the outperformance of low-volatility stocks. Apart from those ETFs that are specifically focused on that part of the market, let's talk about mutual funds that you think of as being lower volatility that you think are good picks and easy for investors to own?
Zimmerman: I think on these segments before, I have talked about, I cover Oakmark, the Oakmark family of funds. It's a very interesting shop, and you look at a couple of their concentrated funds, one in particular, Oakmark Select. About 20 names typically in that portfolio, and it's the cream of the crop from the point of view of manager Bill Nygren, who also runs the more expansive, but still not super expansive Oakmark Fund.
Oakmark Select, you would think with that concentration it would be a far more volatile fund, and it is at the margins, but only at the margins. And so what you are getting in that fund is somebody who has proven himself to be quite an effective stock-picker over the course of many, many years, and only marginally more volatile than the Oakmark Fund has been over the course of a good many years. So, to me that is a good combination. It doesn't exactly take advantage of the low-volatility premium, but in the context of a concentrated vehicle, it does.
There is another fund, U.S. Global Leaders Growth, it's a John Hancock fund that I like quite a lot as well. It is also concentrated: 20-25 stocks is how many that fund typically has, and it is lower volatility in terms of standard deviation, in terms beta, in terms of Morningstar risk, in terms of Sortino ratio, which is another gauge of volatility that penalizes downside performance. It is less volatile on any of those measures, and a really sturdy, strong performer over the long haul, too.
Benz: Shannon, thanks for the recap of all the research going on in the group. It's great to sit down with you.
Zimmerman: Thank you, Christine.
Benz: Thanks for watching. I'm Christian Benz for Morningstar.com.