The Independent Market Observer

Low Volatility in a High-Volatility World

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Jun 15, 2012 1:10:59 PM

and tagged Debt Crisis, Europe, Economics Lessons

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There was more in the papers today about Europe, as the situation continues to evolve amid lots of hand-wringing about what can be done to save the region. The problem is not going away. We are facing a continuing series of what will be perceived as crises—a “hurricane season”—that will result from each country’s decision about whether to remain in the eurozone, and give up much or all of its budgetary and fiscal sovereignty, or go independent. Some, like Greece, might not end up with the luxury of being able to make the decision for themselves.

Right now, we are seeing Hurricane Spain, which will be followed shortly by others. The UK is putting flood walls in place—to extend the metaphor—and reports are that central banks around the world are readying rescue operations in case the Greek elections result in even more political and financial turmoil. What we have learned at this point is that volatility will certainly continue.

So what the heck should we do as investors? I was at a conference sponsored by AQR the other day and was reminded of a counterintuitive fact known as the low-beta effect—that, in aggregate, low-beta stocks outperform high-beta stocks over time. In other words, lower risk, with risk expressed as volatility, has generated higher returns. This is the opposite of what we should expect, but it has been a consistent, empirical fact.

The exact reasons for why the low-beta effect occurs are up for debate. There are several good candidates, with leverage aversion the leader. Personally, I think it is probably a mix of the leading candidates. What matters, though, is the fact, which suggests to me that a focus on lower-volatility stocks makes a lot of sense in the current environment, where volatility can reasonably be expected to show up at some point—maybe soon.

This actually dovetails nicely with other somewhat counterintuitive investment truths, such as that companies that pay dividends generally outperform companies that don’t over time. Dividend-paying companies also seem to exhibit lower betas—though I have not seen research that tests this—which would tie the two effects together even more directly. There are other, similar effects at work as well. Some good discussion of systematic return patterns can be found in What Works on Wall Street, by James O’Shaughnessy.

Taking advantage of these effects can potentially benefit investors in two ways. The first, of course, is potentially lower portfolio volatility. The second, hopefully, is potentially better returns. In any event, this type of strategy diversification should help mitigate portfolio risk. Even in a risky environment like today, there are ways to invest in equities that can help take some of the risk off the table. Strategy diversification can mean looking at the same assets in a different way—something that is good for everyone to do at least occasionally.

There is no guarantee that a diversified portfolio will enhance overall returns or outperform a no-diversified portfolio and diversification does not ensure against market risk. No program can guarantee that any objective or goal will be achieved. Past performance is not guarantee of future results.

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