Less Risk equals more reward?

[pkcrafter]

"When less risk equals more reward" is the title of an interview Christine Benz did with Shannon Zimmerman.

it turns out that less risk, if you define risk as volatility, actually leads to more rewards. There is a low volatility premium akin to the small-cap premium or the value premium that investors are more widely aware of.

There are a few jewels in this interview that might prompt some response.

http://www.morningstar.com/cover/videoc ... ?id=553205


Paul

[Bill R TechSpec]

That's because volatility is only rewarded when you're invested in the right assets. From the CAPM:
E(P) = correlation(P,M)*StdDev(P)*[E(M) - R]/StdDev(M) + R

So as you can see, if correlation(P,M) is very low then E(P) can be small or even negative, even if StdDev(P) is high. Also when the total market has poor prospects such that E(M)<R, then all asset characteristics which would normally be rewarded will be penalized (and all asset characteristics that would normally be penalized will be rewarded) because the sign of [E(M) - R] is reversed.

[staythecourse]

Someone please link the 5, 10, 20 year rolling returns of different asset class returns and S.D. since 1926 and one will see remarkable that return and risk are directly related. There is you data that proves EMH. Also, it passes the "smell" or "common sense" test, as far as I'm concerned. IF low volatility funds did better then why would anyone invest in high risk funds... must be because they like bumpy rides??

Makes me wonder how some of these folks get to give their opinions.

Good luck.

[stratton]

Here's the paper:

Low Risk Stocks Outperform within All Observable Markets of the World

The fact that low risk stocks have higher expected returns is a remarkable anomaly in the field of finance. It is remarkable because it is persistent – existing now and as far back in time as we can see. It is also remarkable because it is comprehensive. We shall show here that it extends to all equity markets in the world3. And finally, it is remarkable because it contradicts the very core of finance: that risk bearing can be expected to produce a reward.

Financial Times Beyond Brics blog has a post on this. The blog post has a link to the paper and a larger FT article with more details than the blog post.

Fund file: Risk does not pay

Counter arguments:

Antti Ilmanen, managing director of AQR Capital Management thinks the time period given for the research was too short to be conclusive.

Fiona Frick, chief executive of Unigestion, distrusts the research as being too simplistic: ”It is true in some kinds of environment such as volatile markets where corrections occur but in bull markets high-risk equities tend to outperform [low-risk ones].”

The reports’ authors report they are seeing evidence of growing interest in low-risk stocks, but Ilmanen reminds investors that low-risk stocks did not fare well in the “junk” rally of 2009. ”Nothing works all the time,” he says. Now that sounds like more sensible advice.

Paul

[Kevin M]

Toward the end of the interview ...

Oakmark Select, you would think with that concentration it would be a far more volatile fund, and it is at the margins, but only at the margins. And so what you are getting in that fund is somebody who has proven himself to be quite an effective stock-picker over the course of many, many years, and only marginally more volatile than the Oakmark Fund has been over the course of a good many years. So, to me that is a good combination. It doesn't exactly take advantage of the low-volatility premium, but in the context of a concentrated vehicle, it does.

There is another fund, U.S. Global Leaders Growth, it's a John Hancock fund that I like quite a lot as well. It is also concentrated: 20-25 stocks is how many that fund typically has, and it is lower volatility in terms of standard deviation, in terms beta, in terms of Morningstar risk, in terms of Sortino ratio, which is another gauge of volatility that penalizes downside performance. It is less volatile on any of those measures, and a really sturdy, strong performer over the long haul, too.

So, who is ready to dump their Total Stock Market fund for either of these funds holding 20-30 stocks?

Kevin

[SimpleGift]

Oy vey, another financial anomaly found in backtested stock market data. Now we can look forward to long, scintillating Boglehead discussions of point/counterpoint that will question in detail (warning, irony to follow):

1) Is the low volatility premium really a (lack of) risk story?
2) Will it continue ex ante? Can it be found in other historical periods and countries ex post?
3) Is the premium already being arbitraged away as we speak?
4) When will Vanguard be coming out with Low Volatility Index Funds? Will these actually capture the premium?
5) Is there a timing strategy for volatility, based on Shiller's historical stock data (a V/10 ratio)?


Source: Alliance Bernstein

[grayfox]

Here's the paper:

Low Risk Stocks Outperform within All Observable Markets of the World

The fact that low risk stocks have higher expected returns is a remarkable anomaly in the field of finance.

OK, right from the very first sentence in this paper I have something to disagree with.

If you read the paper, they looked at stock market from 1990 to 2011 and observed that low volatility stocks had higher returns. So that is actual realized returns, over a period in the past.

But the sentence says higher expected returns, which is about future. The paper doesn't show that expectations are higher.

This is very sloppy work. They conflate actual returns and expected returns. Stock A can have higher expected return than Stock B ex-ante, but the actual returns can be reversed ex-post. In fact, over shorter periods this is not unlikely. Most people would say that stocks have higher expected return than bonds, but there have been periods when the actual returns were reversed and bonds beat stocks.

Another thing wrong in the first sentence is that they use the term "low risk stocks" when their research is about "low volatility stocks". They interchange "low risk" and "low volatility". Again, a sloppy substitution of the word risk for volatility which leads to the to-broad conclusion that low risk has higher return.

If I'm confusing anyone here is the problem in a nutshell:.

They say: Low risk stocks have higher expected return.
What they actually showed:
Low volatility stocks had higher actual returns over the period 1990-2011

What they are claiming is very broad and goes against conventional wisdom. What their data actually shows is more narrow and is not at all inconsistent with conventional wisdom.

[richard]

If higher risk always led to higher returns, it wouldn't be higher risk.

Volatility is not risk

The period examined is too short

[pkcrafter]

Richard wrote:

Volatility is not risk

That was my first thought as well.

M*s Zimmerman uses JHancock Global Leaders has an example of a good low volatility fund, but consider this: The fund is lg growth and has a front-end load and an ER of 1.26%. It holds 29 stocks and has a turnover of 69%. The M* 10 year upside capture ratio is 82 and downside capture ratio is 81.


Paul

[Muchtolearn]

I always hate when people say volatility equals risk. Imagine an asset that went through the following prices on a yearly basis. 1. 2. 4. 8. 16. The volatility is huge.

[Bill R TechSpec]

If higher risk always led to higher returns, it wouldn't be higher risk.

Volatility is not risk

True that volatility is not risk, but neither does risk lead to higher return with any consistency whatsoever because if it did then statistical arbitrage could be used to make it always lead to higher return, which in turn would mean it wasn't risky to begin with. What volatility is is a measure of leverage. So if it's a good investment then volatility/leverage will be good and enhance returns and if it's a bad investment then volatility/leverage will be bad and hurt returns. So it's not risk that's linked to return, it's volatility that's linked to return (which is sometimes misidentified as "risk" because volatility can also be a source of risk, even though it's not the only one).

Problem with the video/discussion is that they're comparing different investments of different volatility without equalizing other factors. This tells us nothing about the importance of volatility due to the confounding variables.

[xerty24]

Imagine an asset that went through the following prices on a yearly basis. 1. 2. 4. 8. 16. The volatility is huge.

and the fair market price is something close to $16 if that is known. Just wait a year and sell at $16 for a profit. If the future is not known (as usual), something that just went from $4 to $1 looks pretty risky, since while a few such stocks rebound to $8, most keep going all the way to zero.

[zotty]

Oy vey, another financial anomaly found in backtested stock market data.

+1

Yet another data starved investing thesis. 90 years doesn't generate enough data points for rigorous statistical work. It's more akin to astrology than to statistics. I don't believe any of these 'premium' theses. Not enough data, not even close to enough data. After a 10000 years, we'll discover that Mid Cap Growth is the sweet spot.