Low-risk stocks do better in the long run than high-risk stocks. For the record, this story equates risk with movement or, in stock market jargon, volatility. In itself, this is not the correct definition of risk. The flip side of risk in the form of volatility is opportunity.
The Chinese character Wei Jie has two meanings for a reason: it stands for crisis (risk), but also for opportunity and challenge. High volatility can be a source of alpha in the context of buying low, selling high (timing, in fact the only source of alpha). But, as so often, what matters most is how investors react to volatility.
Unfortunately, most people tend to buy at high prices and sell at low prices. Then an investor realises the real risk of investing and that is permanent loss of wealth. Low-risk stocks seem to be made for the bear market. They provide a refuge from downside risk just when an investor needs it. Since historical context indicates that stocks may fall further, it is not too late to buy low-vol stocks.
Low-volatility stocks
The Federal Reserve has indicated that interest rates need to rise further to bring inflation under control. Although low-volatility stocks can also be sensitive to interest rate movements - especially if they have been bought in the past as an alternative to bonds - the long-term impact of interest rates is not as great.
The disadvantage of low-volatility stocks is that they beat the market on the basis of a high Sharpe ratio. In rising markets, they tend to lag behind the broader market movement, something for which the investor is amply compensated in falling markets. In the long term, this allows the market to be beaten, precisely by taking considerably less risk.
This year too, low-volatility shares only accounted for 60 percent of the correction, which meant that a solid outperformance could be achieved. After a strong correction, the tendency is quickly to assume that the worst is behind us, which may explain the remarkably strong bear market rally. The start of the bear market compared to similar periods in the past shows that, in terms of size, this was the ninth largest correction in the US equity market since 1928. This time, however, it took the stock market only 118 trading days compared to an average of 268 trading days.
More in the pipeline
So there is more in the pipeline. The combination of the effects of the pandemic, supply-side disruptions, the war in Ukraine, rising tensions between the US and China and the end of a period of monetary madness is likely to leave even deeper marks on the stock market.
Investing in low-volatility stocks is often seen as a way of considering defensive stocks. These are stocks in the food sector, utilities and stocks that are effectively an alternative to a bond. The relatively high dividends of these companies make them popular in a low interest rate environment. As a result, many investors are quick to assume that the same stocks will lag when interest rates rise. But a portfolio of low-volatility stocks is different from a low-volatility portfolio. In the latter case, it is possible to prevent such a portfolio from becoming one-sided and not consisting exclusively of defensive stocks.
A major advantage of a low-volatility portfolio is that losses can be recouped relatively quickly. The importance of limiting large portfolio losses is often underestimated. Certainly after fifteen years of bull markets, many investors no longer see the added value of a low-volatility portfolio. After all, in order to beat the market during the past fifteen years, they had to take more risk, not less.
Investors find it hard to deliberately stay behind the stock market when markets are rising, especially when they know that equities rise more than 70 percent of the time. But the added value can only be seen over the entire cycle. That is when low-volatility shares prove themselves: a return equal to or better than the market, but with much less risk.
Favourable moment for timing
In a portfolio, equities quickly become the most important risk component. If you want to reduce the risk of a portfolio, you should do so within the share class. Equities with an asymmetric probability-risk distribution are particularly interesting. The addition of low-volatility shares can also mean that more risk can be taken elsewhere. If, in a neutral portfolio, one third of the equity part (i.e. one sixth of the total portfolio) is allocated to low-volatility shares, over the past 25 years the average annual return has increased by 5 percent and the risk has decreased by 5 percent.
Low-volatility stocks can fall sharply if there is a bubble. This was the case during the dotcom bubble. The only way to beat the stock market then was to buy the stocks with the highest volatility. Strikingly, low-volatility stocks have also lagged behind in the post-corona boom, possibly reflecting the speculative nature of this upward phase, driven by exuberant monetary liquidity.
Fortunately, such a relatively bad period is normally followed by a quick (relative) recovery. This, combined with the continuation of the bear market, makes the timing of including low-volatility stocks in the portfolio relatively favourable. It is not entirely coincidental that low-volatility stocks are now relatively cheap and that the low-volatility factor therefore even partly coincides with the value factor.
Han Dieperink is chief investment strategist at Auréus Asset Management. Earlier in his career, he was chief investment officer at Rabobank and Schretlen & Co. This article originally appeared in Dutch on InvestmentOfficer.nl.