A Cautionary Tale

Just When You Don't Need It
Low-volatility strategies are the rage. Standard investment theory says that securities that have lower risk should also have lower expected returns because investors will accept smaller profits in exchange for greater safety. (The Capital Asset Pricing Model applies this principle to the stock market and uses the term beta. Thus, the higher a company's beta, the higher its expected return.) However, it hasn't worked that way in practice. For 20 years now, academics have realized that U.S. stocks don't conform to expectations; if anything, lower-risk stocks outgain higher-risk companies. More recently, they've extended this research to other assets and other countries and largely have found the same pattern.

As a result, institutional money managers and now a few retail funds have created "Low Volatility" portfolios. Less risk for equal or even better return? What could go wrong? Well, a couple of things.

One is that the lunch might not in fact be free. It may have a price that is hidden. Such is the argument of James Xiong, Tom Idzorek, and Roget Ibbotson (two Morningstar researchers and the founder of Morningstar's Ibbotson business group) in "Volatility vs. Tail Risk: Which One is Compensated in Equity Funds?" The trio examined 30 years' worth of mutual fund performance and determined that yes, lower volatility does not lead to decreased performance. For U.S. equity funds, the outcome is symmetrical; funds with average standard deviations show the best aggregate gains, while those with the lowest and highest risk land at the bottom (with identical results, as it turns out). With funds owning foreign equities, the effect is more strongly in favor of low-risk funds, as they have the best performance and the high-risk funds have the worst.

However, standard deviation is but one way of measuring risk. Another is to look at so-called tail risk, which examines how a fund performs under extreme conditions. The researchers used a statistic called excess conditional value-at-risk, or ECVaR, that evaluates how a fund behaves during sharp downturns. Effectively, ECVaR measures if a fund suffers particularly bad results when stocks are plummeting. The trio found that if ECVaR is used to calculate risk rather than standard deviation, mutual fund results line up according to standard investment theory. That is, the lowest-risk funds as measured by ECVaR have the weakest future returns, and the highest-risk funds have the best. This holds true for both U.S. and foreign equities.

So, from the perspective of tail risk, the markets are efficient. You get what you pay for.

Rate Sensitive
The second concern--a perpetual concern for investment studies--is that low volatility might be related to another, more primary factor. In other words, stocks that register low volatility may share something else in common, and if that something else runs into trouble, so will the pool of low-volatility stocks. Such is the argument of Eric Nelson in "Don't Get Lured Into Low-Volatility Strategies." (He tipped his hand with that title.) Nelson claims that low-volatility stocks tend to be sensitive to changes in interest rates. This was all fine and good during the great 30-year bond bull market of 1982-2012, but it won't be helpful in the future. Nelson points to this May's results, when low volatility lost money along with bonds, even as the rest of the stock market was up.

I'm not sure how broadly the argument of interest-rate sensitivity can be applied. The strategy of low volatility has been tested on market data that predates 1982, as well as on other asset classes. The strategy is not a one-trick pony. On the other hand, it's true that current low-volatility U.S. stock portfolios are sensitive to changes in interest rates. That's something worth knowing.

There's No Place Like Home (Unfortunately)
James Montier of GMO arrived at the Morningstar Investment Conference croaking the firm's usual tidings of woe. GMO was perhaps the most vocal critic of the late 1990s' technology-stock bull market, and it hasn't become much happier over the years. Its current target, predictably, is fixed income. Conventional U.S. bonds, Treasury Inflation-Protected Securities, and international bonds (hedged from currency exposure) all meet with GMO's displeasure. The company's seven-year forecast for the three investments, expressed in real annualized terms, is negative 1.45, negative 2.3%, and negative 2.5%. Even cash is just break-even. Only emerging debt at a modest 0.7% is positive.

This being GMO, it finds no consolation in U.S. stocks, either, as their forecasts are similar to those of U.S. bonds, at negative 1.3% for large companies and negative 2.6% for small companies. However, GMO does make an exception for U.S. "high quality" stocks (that is, highly profitable companies with low debt), up 3.4%, and it is almost giddy about foreign securities, with emerging-markets stocks scoring the highest at 6.2%.

One set of forecasts from one money manager. That said, GMO's work is sound, and it has a good track record of getting the big picture right. The presentation has me wondering if I should be owning more international stocks. 

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.