For higher returns investors should look to low volatility stocks, according to a white paper by Toronto and Chicago-based BMO Global Asset Management (BMO GAM).
“As this paper says and as other academic research shows the tolerance for risk hasn’t really been rewarded,” says Rajiv Silgardo, co-CEO, BMO GAM in Toronto. “You may have wanted to take more risk with your equity positions but at the end of the day on average you didn’t do as well as people who were more conservative with their equity investments.”
The paper, called Finding opportunities through the low-volatility anomaly, compares the capital asset pricing model (CAPM) alphas (based on U.S. stocks) of five volatility quintiles between 1970 and 2011. The data shows that within that time the lowest volatility quintile had an alpha of 5.14% compared to the highest quintile which saw negative returns of -7.42%.
There are several reasons for the success of lower volatility stocks, according to BMO GAM. One reason is that the growing interest in benchmark-driven strategies, such as index funds and exchange traded funds (ETF)s, distorts the market and leaves low volatility stocks undervalued. Other reasons include the investor perception that high volatility stocks are glamorous – in keeping with behavioural finance principles – and that compensation structures encourage money managers to avoid low volatility investments in favour of higher risk stocks.
While the data used in the white paper is from the United States, the findings are still applicable to global markets, including Canada, says Silgardo. One of the big advantages to focusing on low volatility stocks in the Canadian market, according to Silgardo, is that it allows for exposure outside of the dominant sectors of the TSX – financials, energy and materials.
“When you’re looking at volatility,” he says, “you can construct a portfolio that is more diversified and that in itself will not only lower your volatility, but give you the benefits of diversification which is basically a more consistent return profile overtime.”
The paper’s authors, Ernesto Ramos, managing director, head of equities, BMO Asset Management U.S. and Jason Hans, director, portfolio manager, BMO Asset Management U.S., suggest that every investor should consider low-volatility equity. However, conservative investors nearing retirement in particular, says Silgardo, would be prime candidates for this investment strategy.
“People like that would find these types of strategies very appealing,” he says, “because not only do they lower the risk in your portfolio but it turns out, historically anyways, they give you a higher return.”