Changing The Way You Think About Industry Risk And Return

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This article demonstrates that in a dataset stretching back to the pre-Depression era, sector returns have been negatively related to their realized risk.

Over very long-time intervals, investors have earned higher returns in lower risk sectors of the market, which deviates from what is expected in theory.

Elevated multiples on lower risk stocks have given investors pause that the Low Volatility trade is coming to an end.

This analysis might suggest that lower risk industries should command a premium in the market given their long-run outperformance.

At its root, investing is about risk and return. We want to be well compensated for the risks we take. Rational investors should not be willing to take a more volatile path to get themselves to the same level of cumulative wealth in the future. If we take more risk, we want to get paid for it. However, as I have written in many past articles, higher risk investments have unfortunately not rewarded investors with higher returns.

In Monday's article, I demonstrated that the risk and return of the nine main S&P 500 sectors has been negative since 1998. The highest risk sectors generated the lowest returns, and the sectors with the highest realized risk generated the lowest returns. The graph below demonstrates the relationship discussed in that article.

While I was using the longest available dataset I could pull from Bloomberg for that article, I was still left with a couple of questions. Had the acute sector stress of the Tech Bubble, Financial Crisis, and recent commodity drawdown uniquely impacted those sectors? Did steadily lower interest rates favor consumer staples stocks and utilities? Was this relationship a function of a unique historical period? If so, it might be dangerous to extrapolate findings into the future.

As long-time readers are aware, when I need an expansive time horizon for market studies, I turn to the voluminous dataset of Dartmouth professor Kenneth French. He has grouped industry returns into subgrouping ranging from 5 industries to 49 industries. For my examination, I used 30 industries for two reasons. First, thirty carries special meaning as a representative sample size in statistics. Second, each of the monthly return series was fully populated at this number of industries.

The relationship confirmed what we saw in the 1998-2016 data on the major S&P 500 sectors. There has been a negative relationship between risk and return of sectors of the domestic equity market in this dataset stretching back nearly 90 years.

I have included a table of the thirty industries with annualized returns, an annualized volatility measure, and a ratio to describe risk-adjusted returns. The list is sorted in descending fashion by that ratio. Food, essential to human survival, generated the highest risk-adjusted returns. Tobacco, a product so addictive that it became heavily regulated more recently in the dataset, ranked second. Healthcare, another essential service had the third highest risk-adjusted returns. Steel and coal, two declining domestic industries that have seen global pressure, generated the worst risk-adjusted returns.

Take a moment to look at this chart - I believe there should be meaningful takeaways for Seeking Alpha readers as they think about the long-term asset allocation and industry selection. I think readers could probably do a fairly representative job of placing these industries in an ordinal fashion based on realized risk. We know that beer has more steady sales than automobiles, and that utilities are more stable than construction businesses. I am less certain that readers would have ordered the returns quite as well.

Over long-time intervals, less risky industries have generated both higher absolute and risk-adjusted returns. For those bemoaning the faddish nature of low volatility investing, this relationship has held over a period stretching back to the administration of Calvin Coolidge. I continue believing that investors should keep an allocation to low volatility stocks. One of the leading large cap funds is the Powershares S&P 500 Low Volatility Index (NYSEARCA:SPLV), which includes the one hundred lowest volatility stocks in the S&P 500 (NYSEARCA:SPY), rebalanced quarterly. That fund is industry agnostic, but will tilt towards lower risk industries populated by less volatile stocks. Powershares also offers small cap (NYSEARCA:XSLV) and mid cap (NYSEARCA:XMLV) strategies that have generated historic structural alpha.

In the literature on low volatility stocks, I believe this industry view is unique, and I hope that it helps elaborate on this theory.

Disclaimer: My articles may contain statements and projections that are forward-looking in nature, and therefore, inherently subject to numerous risks, uncertainties, and assumptions. While my articles focus on generating long-term risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance, and investment horizon.

Disclosure: I am/we are long SPY, SPLV, XSLV, XMLV.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.