This isn't how bull markets are supposed to work.
In times of rising prices, more volatile stocks are supposed to outperform. After all, from a theoretical perspective, the whole benefit of holding on to more volatile names is that they produce more generous returns.
But over the past five years, that simply hasn't happened. S&P's index of the 100 least-volatile S&P 500 stocks (rebalanced quarterly) has risen 78 percent over the past five years, nearly matching the S&P 500's 95 percent gain.
Because less-volatile stocks tend to pay out a fatter dividend, the low volatility index has gotten even closer on a total-return basis, rising 108 percent versus a 117 percent gain for the S&P 500. And all while trading with less volatility and a significantly lower beta.
"It's pretty striking," remarked David Seaburg, head of equity sales trading at Cowen & Co., in a Friday "Power Lunch" interview. "It goes to show you that risk doesn't necessarily mean better returns. You can stay in some of these really low-beta names or low-volatility names and outperform the market over a long period of time."
The point is that less-volatile stocks don't have to beat or even keep up with the S&P 500 in rising markets. As long as they come close, their superior performance in falling markets will likely make them better investments in the long term.
That strikes at the heart of the critical finance theory which holds that the volatility of a stock, or at least how volatile it is in relation to its correlation with the market (the measure captured by beta) should determine its returns. But the performance of low-volatility proves that, at best, there are some serious exceptions to the rule.
One theory for the outperformance of the low volatility index versus expectations (and the primary one propagated by its designers at S&P Dow Jones Indices) is something known as the "lottery effect."
That is, we know that some people like to buy lottery tickets even though they know that they are an awful investment likely to lose them money in the long run. Similarly, people may pick highly volatile stocks for the same outsized-return-seeking reasons, leading them to be overvalued over the long run. In fact, it may not be that low-volatility stocks outperform, so much as that high-volatility stocks underperform.
A second, and not necessarily contradictory, theory challenges one of the assumptions about why beta is supposed to matter.
The capital asset pricing model holds that the gains of a given stock will be dependent solely on a mix of its returns, its beta and the premium that investors need to earn in equities as opposed to in risk-free assets. However, in order to prove this, the capital market theory holds that investors can allocate freely among the risk-free asset and stocks, which includes the ability to be short the risk-free asset in order to buy more stocks.
The problem is, borrowing money at or near at the risk-free rate is not something many investors can do easily. If they want very high exposure to the market, then, they may pick highly volatile or high-beta stocks instead—leading such names to be overvalued in a longer-run context.
Either way, the benefits to overallocating to less-volatile stocks are clear.
For that reason, Seaburg would advise looking closely at the PowerShares Low Volatility ETF (SPLV), which tracks the low volatility index.
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