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ETF Specialist

The Low-Volatility Strategy

Though low-volatility equity strategies are backed by an impressive body of research, U.S. stocks are looking pricey.

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Low-volatility stocks tend to be big, boring, and dividend-paying.  HJ Heinz Company (HNZ) is a classic example. Boom or bust, Heinz ketchup sells with clockwork regularity, insulating Heinz's earnings from the business cycle. Stocks like Heinz are as bondlike as they can get. Interestingly, in nearly every market studied, low-volatility stocks have greatly outperformed high-volatility stocks on a risk-adjusted basis, a finding at odds with many investors' notions of risk and return.

There are three compelling reasons why this may be the case. The best is leverage aversion. Investors who target above-market returns may be unwilling or unable to use leverage to reach their expected-return targets. By resorting to volatile stocks (more accurately, high-beta stocks), which theoretically should outperform less-volatile stocks, they hope to earn above-average profits. Ironically, their collective bet on high-beta stocks leads to low risk-adjusted returns. Another is the fact that high-volatility stocks are systematically overpriced by investors seeking "lottery tickets"--stocks with a small chance of huge upside (Tesla Motors (TSLA), for example). Finally, asset managers tied to benchmarks and unable to employ leverage actually have a disincentive to own low-volatility stocks with below-average expected returns, regardless of how fabulous the expected risk-adjusted returns may be, and an incentive to own high-volatility stocks with above-benchmark expected returns, even if their prospective risk-adjusted returns are terrible.

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