Apple, Twitter, Facebook, Tesla. They've all got one thing in common—you've heard of them. Everyone has an opinion about their stock, and lots of investors love them.
But should you invest in them? Many researchers are convinced that you might be better off avoiding these most popular and volatile stocks. Instead, invest in the boring. Low volatility investing is gaining traction and the evidence is mounting that it works. So is low vol the way to go?
According to a new paper to be published in Journal of Portfolio Management by Feifei Li, head of research at Research Affiliates, low volatility portfolios have beaten a cap-weighted U.S. stock portfolio by 1.84% per year between 1967 and 2012, while at the same time exhibiting 19% less annual volatility. Globally the results were even more impressive—3% higher annual returns with 27% less volatility. Higher returns and less risk. Sounds like a no-brainer.
Nardin Baker, chief investment strategist for Guggenheim Partners, has been studying the benefits of low volatility investments for years and agrees that more advisers should be incorporating low vol investments in their core portfolio. According to Baker, overweighting low volatility "can help an investor get a greater total return for the risk that they take."
Even with similar returns to a conventional portfolio, lower volatility gives a portfolio a boost in Sharpe Ratio (excess return per unit of risk). "That, in our view is the objective of investing," says Baker. "It's not to get the highest return, it's to get the highest return for the level of risk that they take."
The most appealing feature of low volatility investing is not necessarily that you are able to find undervalued securities—it is that you avoid the ones that tend to be overvalued. Research on market sentiment shows how stocks that win the popularity contest don't perform well in the long run. Baker notes that less volatile stocks tend to be companies that "have been around for a while, that tend to throw off good dividends, that have stable or predictable sales and earnings. And these stocks give investors a good return for the risk that they're taking." Warren Buffett has long championed the appeal of these less risky companies with stable cash flows.
Low volatility can be lumped in with small cap, value, momentum, illiquidity and low beta as factors investors can overweight in order to gain a performance edge. Each has been shown in the finance literature to provide a little bit of extra return for the same amount of portfolio risk. Although that doesn't jibe with efficient markets where only systematic risk should determine returns, Baker believes that "over the last five years the grip of efficient market academics has been first loosened and now it's being broken." Advisors who keep up with the literature can add value by increasing exposure to these factors.
Li also finds that low volatility isn't as much of a secret as it used to be. Less than $10 billion was invested in low vol in 2010, but by March 2013 that rose to nearly $60 billion globally. And the number of asset managers specializing in low vol investing nearly tripled. So low volatility may have worked in the past, but a lot of money has flowed to this strategy in recent years. Whether you decide to jump on the bandwagon depends on whether you believe that the low vol story is going to last.
The problem with investment anomalies is that when they get identified, they go away. I spoke with low vol expert Eric Falkenstein, quantitative strategist at Prime River Capital Management, who brought up the momentum effect (where yesterday's winners are more likely to win tomorrow and vice versa). "It's hard to find momentum in the cross sectional data since 2003," notes Falkenstein. "Nobody ever understood why momentum exists. And it seems to have gone away—10 years is a long time for it to not work."
Is the low vol premium in danger of disappearing? Nobody knows for sure, but we do know the reasons why it existed in the past. If these reasons persist, then so will the low vol advantage. Despite research showing the recent flow into low vol securities, many believe that there are fundamental explanations for the success of boring stocks.
Explaining the Phenomenon
The first reason is that low volatility means less upside potential. Li believes that there is a subset of investors who see stocks as lotteries. Are Twitter investors likely to hold the stock for five years? Probably not. They have a limited attention span and are attracted to shiny things. They want the potential to score big time so they have a story to tell their friends about how clever they are.
This resonates with Falkenstein, who imagines the difficulty of selling a stock that nobody's heard of versus selling Apple. "There's a lot of reasons why you might want to buy Apple, and they're often a very nuanced narrative, and for those people that want to play that game you don't care much about the style—you just think about why Apple's going to take off." Since the average holding period of a stock is only a year, and many stocks get traded much more frequently, the price of that stock is often a function of whether the company has entered the collective consciousness.
