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By Christine Benz | 02-21-2013 09:00 AM

Does Higher Risk Really Mean Higher Return?

Equity investors looking for higher returns should consider low-volatility, less liquid stocks, which outperform their higher-risk peers over the long term, says Zebra Capital chairman Roger Ibbotson.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. I'm here at the Morningstar Ibbotson Conference, and I had the opportunity to sit down with [Zebra Capital chairman] Roger Ibbotson, who discussed some research he presented at the conference about the potential for low-volatility stocks to outperform.

Roger, you presented some research [at the conference], and you looked at the traditional risk/return relationship between asset classes. What the data show are that if you are in higher-risk asset classes like equities you tend to outperform over time. Correct?

Roger Ibbotson: Yes. Of course, that's what our research has shown over the years, say, stocks, bonds, bills, and inflation. The whole purpose of that was to look at risk premiums. We looked at all the different parts; we've found out that stocks beat bonds. We call that the equity risk premium. We found out that long-term bonds beat short-term bonds. We call that either a horizon or an interest-rate risk premium. We find a small stock premium that small beats large. We find a value premium, that value beats growth. We find all these premiums in the market, and most of them are really related to risk. And this is across the different asset classes.

Benz: You recently, though, drilled into the equity universe specifically, and you examined a time beginning in 1972 ending in 2012. And what you found was surprising given what you just talked about that lower-risk equities generally outperformed higher-risk ones. Let's talk about the overall findings there.

Ibbotson: Yeah, I think it's actually pretty amazing because when we look at the overall within the asset classes--so we look at the category and we see, for example, high-beta stocks versus low-beta stocks, the capital asset pricing model--the equity risk premium pays off of risk. 

But it turns out that if you then try to boost it up by buying the high-beta stocks instead of the low-beta stocks, you do end up with more risk, but lower returns. So both high-beta, high-volatility stocks actually have lower returns.

Benz: Within equities you actually sequenced the characteristics that would tend to predict better risk-adjusted performance and low turnover within stocks. Let's talk about what that means that an individual company has low turnover.

Ibbotson: Low turnover means that we look at the share turnover of the company say for the previous year, and you look at how many shares turned over, what percentage of the shares turned over were traded over the total number of shares outstanding. It turns out that the companies that have a lot of turnover have much higher risk, but have much lower returns. It turns out that the companies that have a little less turnover actually have much higher returns and lower risk. So, here again, it's the lower-risk companies that actually have the higher returns.

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