Does Lower Risk Mean Higher Returns?

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.

This has concrete implications for investors, and casts an unsavory light on some of the expensive, high-yield products coming out these days. Does it really make sense to own a fund tracking an index of business-development companies, which fell further than junk-bond indexes during the financial crisis, let alone to lever it? In their collective scramble for higher yields, investors may suffer an irony: worse returns than if they had simply stuck with low-volatility assets.

How I Learned to Love Low-Volatility Assets
Smart investing is often contrarian. According to Morningstar Fund Flows, as of the end of May, bank-loan, multisector-bond, high-yield bond, and world-bond funds were four out of the top five categories by year-to-date inflows. The market is inexorably following its own logic, responding to low yields by shifting into risky assets. While the market in aggregate can seem rational, we've seen many individual instances of irrational or suboptimal behavior. For example, some retirees who were bunkered in ultrasafe assets are now herding into illiquid, volatile bonds. They likely could have achieved their goals with less overall risk by maintaining a slightly more aggressive strategic posture through low- and high-interest-rate regimes. An investor who earned a risk-free 4% in the past with Treasuries and cash would need to venture into junk bonds and high-dividend stocks to maintain his yield today. Yet he's now greatly increased the riskiness of his portfolio, just as risk has become less rewarding. If he had kept slightly more aggressive posture during a high-interest-rate period, he likely would have earned enough to offset today's low, low returns. By blindly following a yield target, our investor was risk-averse when risk-taking was richly rewarded, and a risk-taker when it likely won't be.

Investors looking to maximize risk-adjusted returns should look into lower-volatility assets such as medium-term Treasuries, short-term corporate bonds, and low-beta or low-volatility stocks. They should shy away from risky, ultrahigh-yield products. Thanks to tremendous product diversity in the ETF market, investors have plenty of good, low-cost options.

 Vanguard Dividend Appreciation ETF (VIG) is a team favorite. Its stocks generally exhibit low volatility and have long histories of financial stability. If Warren Buffett had to buy an ETF, we like to think that he'd pick this one. Despite the name, the fund's yield is modest. Rather, VIG screens for stocks that have increased dividends 10 years running, and also applies liquidity and diversification constraints. During the past three years, this ETF has had among the lowest betas of all nonsector U.S. equity ETFs. Its 0.18% expense ratio puts it among the cheapest dividend-strategy funds.

 IShares Barclays 1-3 Year Credit Bond (CSJ) maintains a fairly high-quality portfolio and low effective duration. Its 0.20% fee is reasonable, though as a percentage of yield can be quite a bite. Short duration and high credit quality seem to be the sweet spot for risk-adjusted returns. Admittedly, it's hard to fault broad bond funds like  Vanguard Total Bond Market ETF (BND). In bonds, it's more important to avoid extreme duration or credit risk than to hew to ultrasafe securities.

 

Russell 1000 Low Volatility ETF  and  PowerShares S&P 500 Low Volatility (SPLV) target low-volatility stocks. LVOL uses a black-box model by Axioma, a respected risk modeler, to buy stocks with the lowest realized volatility over the past 60 days, and is reconstituted every month. Axioma's models are designed to maximize low-volatility factor purity while minimizing turnover. SPLV's strategy is more naive, but cheaper and possibly lower-turnover due to its quarterly reconstitution. Low-volatility strategies almost by definition lag during bull markets. They earn their superior risk-adjusted returns during sharp bear markets. LVOL charges 0.49% and SPLV 0.25%.

Higher Returns, Lower Risk
Investors should be wary of barbell strategies, which mix in a dash of highly volatile assets with safe assets. Instead of shooting for the moon with ultrahigh-yield bonds and stocks, consider modestly increasing your allocation to low-volatility stocks. This requires a shift away from an income-focused view of the world, but the economic logic is compelling. If everyone is scrambling for yield, willing to pay large premiums for the prospect of regular income on hand, then low-volatility total return opportunities may become relatively attractive.

An intriguing feature of research into market anomalies is how practitioners anticipate these findings, sometimes by decades in advance. George Soros was a momentum trader before momentum was "discovered" by academics. Warren Buffett is perhaps the most well-known advocate of investing in unloved, stable, dividend-distributing, richly earning companies with highly predictable futures. Surprise, surprise: It turns out almost all of those features are associated with higher returns. In line with Buffett's reasoning and backed up with a wealth of academic research, low-cost, high-quality, low-volatility strategies offer relatively attractive returns to the disciplined investor.

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