The Paradox of Low-Risk Stocks

What You Need to Know

Contrary to conventional wisdom, research shows that less volatile stocks tend to beat the market over the long term, by losing less in downturns. Our own research found that an active approach combining low volatility and high fundamental quality produced even stronger performance. This strategy can be used as a source of uncorrelated alpha or as part of a plan’s overall risk management.

Wanted: A Better Shock-Resistant Equity Strategy

After the serial market jolts of the past decade, investors prize stability as never before. The pressure on plans to reduce funding volatility has only intensified with the passage of new pension-accounting and insurance-solvency regulations. For many investors, this poses a dilemma: they want (and need) equity-like returns, but not the performance swings and downside risk that come with equities. The search for a better shock-resistant equity strategy has sparked interest in a powerful yet long-unappreciated market anomaly—that less volatile stocks tend to outperform market indices over the long term.

Less volatile stocks are inherently less exposed to market booms and busts. They won’t soar as high in bull markets, but they generally won’t fall as much in crashes and, thus, have less to make back when the market recovers. As a result, these “Steady Eddies” typically compound more of their gains over a full market cycle.

The historical outperformance of low-risk stocks defies a central tenet of finance theory, which states that risk and return go hand in hand: accept more volatility and you’ll be paid with higher rewards over time. Yet, academic research confirms that the low-volatility anomaly has been observable for much of the past century. It also spans asset classes and geographies.

We did our own research into this anomaly’s investment potential and found that explicitly targeting both low volatility and measures of fundamental stability, and vetting for nearterm downside risks, produced even stronger results than passive low-volatility approaches.

A Robust But Different Kind of Anomaly

A long-only value, small-cap or price-momentum strategy seeks to deliver above-market returns at similar or incrementally higher levels of risk. In contrast, a low-volatility portfolio, like the physician vowing to "first, do no harm," aims to deliver market-like or better returns at below-market risk. Its strong suit is its protective behavior in crisis markets (Display below). The least volatile quintile of global stocks fared better than the market in seven of the past eight major downturns, including during the recent European debt crisis, when it outperformed the market by 15%.