One of the first things that everyone gets told about investing is that an investor needs to take risk to get returns: the higher the risk, the higher the average return.
This has generally proved true historically in asset classes. Equities are riskier than bonds, and equities outperform bonds over time. Similarly, bonds are riskier than cash, and bonds outperform cash over time.
Within the universe of equities, however, the expected relationship between risk and return appears to break down. In fact, it may surprise investors to learn that portfolios comprised of low-risk shares have earned similar or higher returns than portfolios of higher-risk shares.
There is a persistent mispricing of risk in equity markets around the world, whereby investors are not rewarded for owning riskier shares the way they are rewarded for investing in riskier asset classes.
Equity factors are premiums that explain the risk and return characteristics of a particular share or set of shares. A large body of academic and empirical research supports the theory that gaining exposure to factors results in long-term outperformance versus the key benchmark market cap index. The best-known factor is the one that every investor in equities gains exposure to, whether intentionally or not. This is the market factor, known better as beta.
For each individual share, beta measures the responsiveness of that share’s price to changes in the overall stock market. Beta shows the share’s exposure to the overall market risk. This helps the investor to decide whether he wants to go for the riskier share that is highly correlated with the market (beta above 1), or with a less volatile one (beta below 1).
By multiplying the beta value of a share with the expected movement of an index, the expected change in the value of the share can be determined. For example, if a share’s beta value is 1.3, it means, theoretically this share is 30% more volatile than the market, and the market is expected to move up by 10%, then the share should move up by 13% (1.3 x 10).
The theory goes that investing in high-beta shares, or those with higher variability in relation to the market, should be rewarded with higher returns. But, surprisingly, the reverse seems to be true — taking lower risks has actually yielded higher returns versus the market cap index over the long term.
Nowadays, the common consensus is that there are several factors that can attract a long-term premium over the benchmark index. Among the most popular are the previously mentioned low-volatility, value, small cap, momentum, high-dividend yield and quality factors.
Low-volatility shares are those that simply display low average variation in their prices as measured by statistical measures, such as variance or beta. These companies have very steady earnings streams, in established sectors with established products.
High-growth, innovative companies usually don’t fit the bill and their shares are much more volatile. Low-volatility shares are more usually found in the so-called ‘boring’, defensive sectors.
The standard theory of investments states that an investor needs to be compensated for taking on extra risk through enhanced returns. In other words, returns and volatility should go together and move in the same direction. The low-volatility factor goes against this. An investor can earn superior or largely unchanged returns versus the market cap index, but with less risk or volatility.
There is substantial empirical evidence in South Africa on the benefits of investing in low-volatility equity. In the following chart P Van Rensburg and M Robertson, in the Investment Analysts Journal (January 2003, Issue 58), group stocks by a simple measure of risk and total volatility, and show the average monthly returns of each grouping. The lowest-risk grouping, on the right, has realised the highest returns –not the highest-risk group.
Our long-term study shows low volatility equity investing performs extremely well, relative to a benchmark All Share 40 index (ALSI40) fund. Using data from Salient Quantitative Investment Management, we studied the performance of low volatility from 2003 to 2018.
The low volatility had a return of 20.4% and a volatility 12% over the period, compared with the ALSI40 return of 14.6% and volatility of 16.3%. The biggest reason for the outperformance and lower risk comes from the maximum drawdown. Maximum drawdown measures the largest peak-to-trough decline in the value of a portfolio. During the 2008 financial crisis, the ALSI40 had a maximum drawdown of 43.4%, whereas the low-volatility equity protected capital by falling less than half, with a drawdown of only 19.8%.
Protecting value during crashes and corrections, allows the low-volatility equity portfolio a bigger base from which to grow in the subsequent market rise, resulting in long-term outperformance.
Low-volatility equity performance is cyclical. While it outperforms and protects capital in bear markets, it tends to not outperform strongly during bull markets and can, in fact, underperform for multi-year periods.
Low-volatility equity allows investors to be exposed to the equity market, but at as low a risk as possible. When being included as a building block in a balanced portfolio, it allows a slightly higher exposure to the equity asset class but at the same level of risk.
A low-volatility equity portfolio fits well into an overall retirement fund and may result in both lower total risk and higher expected returns. In volatile markets, a low volatility approach offers retirement funds some comfort that the worst return drawdowns may be avoided. As a result, retirement funds may enjoy larger and lower-risk pension pots for members during retirement.