Riskier investments should be capable of generating greater potential returns – it's only fair. But it's not always true.
In an upending of the risk-return relationship, low-volatility stocks have been shown to perform at least as well as their more volatile counterparts, while carrying substantially less risk.
It's a curiosity that's prevailed over time and across markets, said Bruce Cooper, chief investment officer of TD Asset Management Inc.
"It's what I would call a market anomaly," Mr. Cooper said. "You get much worse performance than you would expect from the most volatile stocks."
There's no guarantee that the anomaly will hold, and low-volatility securities themselves can potentially become overvalued. But there appears to be nothing on the horizon to threaten this anomaly or the appeal of low-volatility securities in lowering risk without sacrificing return, Mr. Cooper said.
After the stock market crashed in 2008-09, which saw every major North American index decline by half in less than one year, investors were not eager to relive the experience.
Low-volatility funds offered a kind of insurance by screening out the least stable segment of stocks, thereby dodging the worst of the market's whims.
Investors were receptive to funds that smoothed out returns and limited the downside, even if they had to forgo some potential gains, Mr. Cooper said.
The fundamental rule that investors are rewarded for taking risks is the general idea behind the Nobel Prize-winning capital asset pricing model.
But data present an apparent glitch to that model, with stock markets seeming to exhibit a flat – or even negative relationship – between risk and reward.
That means that stocks that are less sensitive to market conditions can match or exceed the market's average expected return.
Boston-based fund manager GMO LLC found that from 1970 to 2011, the most volatile one-quarter of U.S. stocks generated an average annual return of 7.2 per cent. The least sensitive quartile, meanwhile, returned 10.6 per cent, and with half the risk, as approximated by volatility.
Several studies have arrived at a similar finding, including TD's own research, Mr. Cooper said. TD launched Canada's first low-volatility fund in September, 2009. The fund has beaten the S&P/TSX Composite Total Return Index over every measured time frame, from three months to inception. Since coming to market, the fund has generated an annual return of 17.2 per cent, more than doubling the index.
The commodity sell-off had a lot to do with that, Mr. Cooper said. "The highest-volatility sectors are resources, so low-vol. funds meaningfully underweight energy and materials."
The reason for the inverted risk-reward relationship in other markets is less clear. There are some common theories.
First, investors tend to chase "lottery ticket stocks," which offer a low probability of extraordinary returns, crowding the trade and making it difficult for flashy stocks to maintain their inflated valuations.
Second, the prevalence of benchmarking for performance measurement forces fund managers into high-volatility stocks to prevent underperforming bull markets, resulting in stretched valuations for these equities.
Both ideas are supported by evidence showing that the most volatile segment of stocks – the 20 per cent that are most sensitive to market fluctuations – tends to be the source of this anomaly.
"You're not sufficiently rewarded in the up markets by the high-volatility stocks to compensate for how badly they do during the down markets," Mr. Cooper said.
The BMO Low Volatility Canada Equity ETF (ZLB) sidesteps those stocks by investing in the 40 stocks with the lowest beta among the largest public companies in Canada.
"It's a good stabilizer, in particular for smaller portfolios, because you get diversification protection as well," said David Cockfield, managing director at Northland Wealth Management. He's owned the ETF for several years. "Look at the chart and you can see why."
Since coming to market in late 2011, ZLB has increased in unit price by 80 per cent, compared to 24 per cent for the S&P/TSX composite index.
Despite recent low-volatility outperformance, Mr. Cockfield prefers to own ZLB and its U.S. counterpart, BMO Low Volatility U.S. Equity ETF (ZLU), for their designed purpose – to smooth out the return profile amid market volatility, which he's expecting through the rest of the year.
"You've got huge gaps between the bulls and the bears, and that makes for volatile markets."
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