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Rekenthaler Report

A Cautionary Tale

Warnings on low-volatility stocks and (yes again) bonds.

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.