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Can you win with low-risk stock strategies?

(MoneyWatch) One of the persistent criticisms of modern portfolio theory is the existence of anomalies, such as the existence of momentum and the poor performance of small growth stocks. An anomaly attracting more attention is the "low-risk" or "low-volatility" variety, which is the inverse relationship between future stock returns and beta (measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole).

The historical evidence demonstrates that low-beta portfolios meaningfully outperform high-beta portfolios in both U.S. and international markets. This runs counter to economic theory, which predicts that higher expected risk is compensated with higher expected return. However, investors must be careful before jumping to conclusions because while strategies have no costs, implementing them does. In other words, an anomaly may exist "on paper," but once costs are accounted for, the anomaly (or at least the ability to exploit it) may disappear.

The authors of the paper "The Limits to Arbitrage Revisited: The Low Risk Anomaly," examined the CRSP data from 1963 through 2010 to see if investors can actually capture the higher returns of a low-beta strategy after costs. To accomplish this objective, they explored the role portfolio rebalancing and transaction costs play in attempting to extract profits. The following is a summary of their conclusions:

  • Low-volatility portfolios outperform even after considering the size and value factors.
  • The excess return of low risk portfolios is present only in the first month after portfolio formation, creating the need for frequent rebalancing.
  • The alphas are largely in low-priced stocks with limited liquidity.
  • Because of the need for frequent rebalancing and the high costs of trading less liquid stocks, outperformance is largely subsumed by transaction costs.
  • The findings were unchanged for various approaches to measuring the low-volatility anomaly.

The bottom line is that investors' ability to effectively extract the excess return from a low-beta strategy is limited, at best. The findings were unchanged for various approaches to measuring the low-volatility anomaly.

Image courtesy of Flickr user Tax Credits.

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