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ETF Specialist

Does Lower Risk Mean Higher Returns?

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

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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.

Samuel Lee does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.