Over the past decade or so, an increasingly powerful body of studies has turned some long-held investment assumptions on their heads. In the 1960s and 1970s, finance academics developed two related ideas known as the “Capital Asset Pricing Model” (CAPM) and the “Efficient Market Hypothesis” (EMH). One held that investment return was directly proportional to risk, while the other viewed markets as inherently “efficient”—that is, that all information was promptly (and rationally) reflected in market prices. The upshot of these ideas was development of indexing, a strategy whereby one simply bought “the market” as measured by a common benchmark such as the S&P 500 Index.
Indexing started off slowly, in 1976, when mutual fund operator Vanguard introduced the first mutual fund that mimicked the behavior of the S&P 500 Index. After a couple more decades of academic studies supporting CAPM and EMH, indexing took off as an investment strategy in the 1990s. The Vanguard S&P fund exploded in assets under management, and numerous other investment firms brought index products to the market.
But just as it seemed everybody was going headlong down the indexing path, the markets seemed to stop cooperating. Since the end of the 1990s bull market, the S&P 500 index (and all the funds that mimic its behavior) has generated average annual returns of only 2.7 percent. And as we know, the ride over the past 13 years has been anything but smooth, frightening the bejesus out of risk-averse investors.
Over the past decade, studies conducted by market participants rather than academics have demonstrated that CAPM and EMH are just plain wrong. When comparing investments of the same type (stocks vs. stocks, or bonds vs. bonds, for example), it turns out that the relationship between risk and return is inverse, not direct. That is, the more risk one takes, the lower the returns one can expect.
Nardin Baker, chief strategist at Guggenheim, an investment firm responsible for managing $180 billion, and his colleague, Robert Haugen, recently published a paper finding that this inverse relationship between risk and return can be observed throughout the financial markets. Baker and Haugen devote most of their paper to understanding why what’s commonly called the “low-volatility anomaly” exists.
But first the evidence. Baker and Haugen divided stocks on the basis of observed volatility, that is, the degree to which stock prices fluctuated over the course of a given time period (volatility is the most widely used measure of financial risk). In almost all time periods, the least volatile stocks outperformed the most volatile stocks by a very wide margin. Baker and Haugen also note this phenomenon is observed in bond markets as well as stock markets and in all the developed and emerging markets they surveyed.
In explaining the anomaly, Baker and Haugen note that the more volatile stocks are typically owned more heavily by professional managers than by the general public. He attributes this phenomenon to several possible sources, but especially to how professional investment managers are compensated and how they deal with their clients. Managers are frequently given bonuses when a portfolio outperforms a benchmark index by a certain percentage, or “hurdle rate.” Although more volatile stocks generate lower returns on average, statistically the chance of a manager exceeding the hurdle rate are actually greater for more volatile stocks than for less volatile ones (anybody who’s interested in how this works can email me a request for a copy of their paper).
Second, Baker and Haugen found that, on average, more volatile stocks get greater coverage by equity analysts than less volatile stocks. Similarly, news coverage in the financial press is more intense for the more volatile stocks, which are often referred to as “story stocks” as a result.
The basic advice Baker and Haugen give to academia is that their widely used textbooks are “dramatically wrong.” For both the average investor and the professional, their advice is that investing in capitalization-weighted equity index portfolios is, at best, an ill-advised core strategy. As Rob Arnott of Research Affiliates has pointed out, capitalization-weighted index investment means you’re buying more overvalued stocks and less undervalued ones. It turns out that the reason for the over- and undervaluation flows from the notoriety of certain stocks.
What’s an investor to do? For our firm, we’re intensely focused on what we believe are the key aspects of business and financial performance and couldn’t care less about news coverage. But for those who don’t have access to the breadth and depth of the information available through costly data services, there are couple things you can do to avoid the volatility trap.
The first is turn off CNBC, or at least view it for what it is: amusing entertainment. Forget the latest initial public offering of the next hot social media company. Focus your investments on consistently profitable companies that share their earnings with their shareholders, typically by paying dividends. Whether it’s nanotechnology or cloud computing or the hottest new fast-food fad, story stocks are for chumps. If you want a good story, go read a good book.
