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Load up on low-risk stocks, short high-risk ones Add to ...

WHAT ARE WE LOOKING FOR? After a month away, quantitative strategist Yin Luo is back, having switched to a new firm, Macquarie Capital. For the month of May he recommends a strategy of buying low-risk stocks and selling short high-risk stocks. PAST PERFORMANCE Mr. Luo has been a monthly guest contributor to this column since it started a year ago. He didn't get a chance last month to update his performance in March until now, but his long/short portfolio based on value and momentum stocks did well. The long side was down 2.4 per cent, while the short side fell 13.3 per cent. Therefore, the strategy generated a return of 10.9 per cent in March. Since he started to contribute to the column, his strategy has outperformed the benchmark in 10 out of 11 months. THEME FOR MAY Mr. Luo has found that low-risk stocks in Canada have performed better than high-risk stocks by more than 10 per cent a year over the past 20 years. For this month, he suggests going long on a group of low-risk stocks and going short on a group of high-risk stocks. The long basket contains stocks with attractive valuation, solid momentum, and low risk (low historical volatility of monthly returns); and vice versa for the short side. He also tried to maintain a sector balance, in order to mitigate having too much exposure to one sector. DEEPER EXPLANATION The following section is a bit complex and is more for students of finance theory. But here it goes. As Mr. Luo explains, traditional finance theory divides a stock's total risk into market-related risk and stock-specific risk. When portfolio managers try to determine how much to pay for a stock based on expected returns, they have to take risk into consideration. The theory is that investors need to be compensated in two ways: time value of money and risk. Or in other words, high-risk stocks demand higher returns to compensate for the extra risk taking. "Our empirical testing, however, suggests something very different," Mr. Luo said. "We found that low-risk stocks actually have been consistently outperforming higher returns in Canada." Why is this? Well, it has to do with how value investing tends to outperform growth investing over the long term. "We found the phenomenon of low risk/high return consistent with the traditional value investing philosophy," he said. "In other words, low-risk stocks are more likely to be value stocks, and therefore tend to produce higher returns."

 

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