The relationship between risk and reward is one of the most fundamental in finance: to get higher returns, say the traditional models, you must accept more risk. There’s just one problem with that idea: it’s not borne out by history. Over long periods, in most markets around the world, stocks with the highest volatility have not been the best performers—and during some periods, the least volatile companies have done significantly better. This low-volatility anomaly has been known since the 1970s, and has gained renewed popularity with the appearance of a number of ETFs designed to capitalize on it.
In the last year or so, BMO, iShares and PowerShares have all launched low-volatitly ETFs in Canada, and each them uses a quite different strategy. I’ll review these later in the week, but first, I’d like to share an excerpt from my recent interview with Jean Masson, managing director at TD Asset Management and an expert on low-vol strategies. Dr. Masson is the portfolio manager for the TD Canadian Low Volatility Class and the TD Global Low Volatility Fund, as well as two institutional funds based on similar strategies.
Can you explain what the data tell us about the relationship between volatility and returns in the equity markets?
JM: Most investors do not like to take risk for no compensation. But somehow, if you look at the history of the stock market in Canada over the longest series we have, you will not observe higher returns on more volatile equities. In the US we have accurate data starting in 1926, and since that time the relationship between risk and return is basically flat—whereas the theory suggests it should be positive. You can sort the performance based on beta or on standard deviation and you get the same result.
When markets are strong, you do see the positive relationship between risk and return, and that is true in Canada, in the emerging markets, in the US, everywhere that I have seen. Let’s say you believe there should be a 4% equity risk premium above bond yields—so these days that might be 6% or 7%—and returns end up being above that expectation. In those environments, it’s typically the riskier equities that do really, really well. But when equity returns are within expectations, then riskier equities do terribly and less risky equities do relatively better. And when the returns of the overall market are not very good, the relationship is actually inverted.
So the theory says less volatile equities should have lower expected returns, but all of the evidence we have shows they do not. If there is no compensation for risk as far back as our data go, and if we think there will be no compensation in the foreseeable future, then our thinking is you might as well minimize expected risk.
And by doing so you can expect higher returns?
JM: We have never said if you reduce volatility you will necessarily have better returns. What we’re saying is that you can take less risk and not sacrifice expected return. Some people are more aggressive and say you can have your cake and eat it too: you can take less risk and have better returns. That is what we’ve observed in the last 10 or 15 years, but I think that’s a little aggressive going forward. Most retail investors chase returns, and low-vol has recently done better, but that’s the wrong reason to use the strategy.
I guess that is the distinction between a low-vol strategy and a value strategy. The former attempts to provide better risk-adjusted returns, but not necessarily returns superior to the benchmark. Whereas a value strategy does attempt to outperform, and not necessarily with less risk.
JM: I agree. The traditional goal of active management is to give you a higher expected return for the same risk. Value managers might build a portfolio of stocks that trade at low price-to-book or price-to-earnings ratios, or high dividend yields, or whatever. They try to find stocks that look cheap relative to their potential. And historically the value style has produced slightly higher returns for about the same risk—let’s say 14% to 15% standard deviation, similar to the index in terms of risk, with slightly higher returns. Low-vol is about giving a similar return to the index while taking a lot less risk—let’s say 30% less risk or so.
Is it fair to say that you could buy a low-volatility fund and simply hold it for your investment lifetime? In other words, low-vol is not a tactical strategy.
JM: That’s right. In the long run the returns compared with the overall market are competitive, and if things turn out badly you won’t go hungry. To me, the core should be low-vol for the long-term: it’s not designed for moving in and out.