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The returns of stocks with less risk?

(MoneyWatch) The recent bear market made investors more interested in low volatility stocks. Several recent academic papers have shown that low volatility stocks have provided basically the same returns as high volatility stocks, thus providing superior risk-adjusted returns.

Ronnie Shah and Wes Crill of Dimensional Fund Advisors looked at the low volatility strategy in their December 2012 paper, "Residual Volatility and Average Returns." They found that high volatility stocks have had abysmally poor returns, but there has been very little difference in returns between low and medium volatility stocks. However, many high volatility stocks are very small, together representing just 2.4 percent of the market. Thus, their impact on a market portfolio is marginal. For example, over the period 1963-2011, a portfolio that buys the lowest 20 percent of stocks based on volatility generated a monthly return of just 0.01 percent greater than the market's return.

Long/short portfolios that short high volatility stocks are unlikely to generate abnormal profits due to the high costs of shorting small stocks and their high turnover.

This paper follows earlier research done by Shah in his paper "Understanding Low Volatility Strategies: Minimum Variance." Summarizing Shah's findings:

  • Low volatility strategies had similar returns with substantially less (about 20 percent) volatility when compared with a market-like portfolio.
  • Low volatility strategies' superior performance could be largely attributed to industry bets and exposure to value stocks. Utility and non-durable goods had higher weights in a low volatility portfolio than a market portfolio.
  • Low volatility strategies also had exposure to term (interest-rate) risk.

Despite these seeming advantages, Shah found that similar Sharpe ratios (risk-adjusted returns) can be attained using a balanced portfolio of stocks and bonds. In addition, once Shah corrected for industry weightings (taking the lowest beta stocks but weighting them by industry in the same proportion as the market portfolio), the higher Sharpe ratio of the low volatility strategy disappeared.

The bottom line is that there's really nothing novel with a low volatility approach. Low volatility strategies had simply benefited from the fact that value stocks had a higher Sharpe ratio than the market over the period studied (1968-2010) and that interest rates fell. Another item to consider is that turnover was about 31 percent a year for a low volatility strategy, more than six times the turnover of a market portfolio. Turnover isn't free, and it's not tax efficient either.

And finally, prior research has shown that stocks that have negative momentum (poor recent returns) and small growth stocks (high price-to-earnings or high price-to-book ratios) have poor returns. A market portfolio with rules that exclude these stocks produces similar results to a low volatility strategy.

Image courtesy of Flickr user 401(k) 2013