The strange anomaly of low-risk stocks

It may not seem it, but these are actually fairly dull times in the stockmarket. Volatility, as measured by the Chicago Board Options Exchange (CBOE) Vix index, has been low for most of this year. When you compare 2012's stockmarket action to the swings and lurches seen since 2008, you can see why.

Stocks have traded in a much tighter range than in any other post-financial-crisis year so far. It may not be very exciting, but as Tadas Viskanta, founder and editor of Abnormalreturns.com notes, you can profit from this low volatility. But to do so, you have to leave behind one of investing's golden rules.

More risk means more return, right?

One of investing's oldest mantras is that the more risk you take on, the higher the return you can expect to earn otherwise, why would you take the risk in the first place? So if you stick to safe, low-volatility investments (low volatility essentially means the returns are quite predictable and not expected to vary much over the period you invest), then you should expect to be beaten soundly over the longer term by someone who invests in spicier assets.

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As Adrian Banner, Vassilios Papathanakos and Phillip Whitman of Intech Investment Management suggest on Institutionalinvestor.com, if you "naively applied" this theory "over a 40-year career, you'd probably want to hold a portfolio consisting mainly of high-risk stocks". After all, as long as you have enough time, and you spread your exposure out over enough stocks, any short-term volatility shouldn't bother you.

So say you did as theory suggested. You invest in high-volatility stocks and every so often review the portfolio, weed out those that have become lower volatility, and replace them with their more exciting peers. The result? "To your horror you would have significantly underperformed a market-capitalisation weighted index portfolio (ie, the standard equity benchmark) within a decade."

Worse still, you would start to realise that holding lower-volatility stocks would have made you more money and have allowed you to sleep better at night in the meantime.

Back to the 1970s

This is no flash-in-the-pan observation. "Papers noting the existence of the low-volatility anomaly appeared as early as the 1970s." From 1968 to 2005, of 1,000 of the biggest American stocks, the least volatile beat the wider market by nearly 1% a year, with 25% less volatility, according to a study in the Journal of Portfolio Management.

A similar study from the Financial Analysts Journal, quoted in The New York Times, found pretty much the same thing. As Harvard professor and co-author Malcolm Baker put it, "when you look back over history there isn't a pattern of higher returns from higher-risk stocks". What's more, the low-volatility strategy works better in both developing and emerging markets.

Why does it work?

It's a little to do with psychology and a lot to do with timing. As The New York Times's Carla Fried notes, "investors have a propensity to make lottery-type bets on long shots". In other words, private investors will often ignore common sense in favour of excitement and the prospect of making a fast buck.

Fund managers, meanwhile, have no reason to follow low-volatility strategies either. They're under constant pressure to beat their benchmarks and their peers. Low volatility might pay off when markets are floundering (see below), but would leave them exposed when markets rally. That's too big a career risk for most managers.

Timing also matters. Low-volatility strategies work best in bear markets: such stocks may go down, but they'll go down by a lot less than the average stock. Between 1968 and 2005, in 12-month periods where the wider market fell, S&P 500 stocks with the lowest volatility fell by 9.3% on average, while the broader market dropped by 14%, according to Analytic Investors.

The trouble is, "you are going to lag, and lag badly, in bull markets", as Morningstar analyst Samuel Lee puts it. That underperformance could be as much as 3% a year. You might not mind that, as long as you're still making money. But sitting out a bull market doesn't appeal to many institutional investors, as it often means losing your clients and eventually, your job.

Can low-volatility investing still work?

Market quirks such as the low-volatility anomaly aren't supposed to last. Once enough people catch on, everyone should pile into low-volatility stocks, driving up prices until they offer terrible value, and the strategy backfires. As Adrian Banner warns, "throughout the history of investing, analysts have promoted various strategies as having the potential to beat the market on a sustained basis. In most cases these claims have been fleeting or entirely unfounded."

However, as David J Merkel notes on the Aleph blog, the good news is that although low-volatility may already be becoming a "crowded trade", anyone who follows this strategy is likely to be tracking "quality" stocks with defensive characteristics (strong balance sheets, low debt and decent cash flow). And while "occasionally investors overpay for quality in general a quality bias pays off over time, as does a value bias".

How to play low-volatility stocks

The easiest way to get exposure to a wide range of low-volatility stocks without having to build your own portfolio is via an exchange-traded fund (ETF). Launched last June, the Ossiam ETF US Minimum Variance (LSE: LUMV) uses derivatives to mimic the performance of the lowest-volatility S&P 500 stocks.

The expense ratio is 0.65%. For those who prefer a cheaper, physically backed ETF, wait for the launch of SPDR S&P 500 Low Volatility ETF (LSE: USLV). This tracks the S&P 500 low-volatility index with an expense ratio of 0.35%. If markets fall back once the latest QE bounce wears off, either fund should offer some protection.