A Trade That Never Wins

by: Ploutos


It has been a golden rule in finance that higher risk should be compensated with higher expected returns in a model that assumes investors are rational and risk averse.

Digging back into a long-run stock market data set covering thousands of stocks, this article examines portfolios formed based on their trailing volatility.

In reality, the highest risk stocks have not only failed to deliver higher returns - they have not delivered even positive returns over long time intervals.

This article demonstrates that over ten-year periods, the highest risk decile has never outperformed the broader market while lower risk deciles have always delivered positive returns.

This article further demonstrates that high risk stocks have lost in both bull markets and bear markets.

All active managers set out to try and beat the market. While many seek to outperform by picking securities that will generate above average returns, the key to continued success may simply be avoiding ones that lag the market.

In a pair of recent articles, I have examined Quality-based investing. The research underpinning these articles led me to hypothesize that the long-run success of Quality-based investing is missing the losers more than finding the winners. That revelation prompted me to revisit some previous work on one of the worst trades in the modern history of the U.S. stock market.

What is this terrible long-run trade? After all, over long time intervals, the U.S. stock market has managed to march higher. This terrible long-run trade is buying the highest risk domestic stocks. The highest risk decile of U.S. stocks has delivered slightly negative returns over the past fifty years. If investors owned the riskiest stocks in the U.S. stock market, they would have not made any money in a period that extends to President Lyndon Johnson's first year in office. To me that is an exceptional fact and further strengthens my desire to tilt towards low volatility and potentially quality stocks.

Source: Kenneth French, CRSP, author's calculations

Much has been made about the popularity of this factor tilt towards low volatility stocks. Some have continued that low volatility stocks could be overvalued as money has flown into this trade, boosting the relative trailing performance but portending lower relative returns in the future. In my last article, I show that the two leading Quality ETFs do not appear to be overvalued relative to the broad market.

Some might argue that they can time a tilt between low volatility stocks and high beta stocks to capture the strong performance of high beta stocks in bull markets. While I have described a strategy that uses momentum to effect this trade, for most long-term buy-and-hold investors, capturing the Low Volatility Anomaly or the Quality Bias in part through missing the underperformance of high-risk stocks is a simple winning trade.

Over the sample period between 1964 and 2016, the S&P 500 (NYSEARCA:SPY) outperformed the most volatile decile by over 10% per year with less than half the volatility. In up years for the S&P 500 when one would expect high beta stocks to be experiencing very strong returns, the broad market index still outperformed the most volatile cohort on average. In down years for the S&P 500, the high volatility decile strongly underperformed, falling by an average of 35% per year and eliminating any of the gains from bull markets in the sample period.

Source: Kenneth French, CRSP; S&P

In up years, the arithmetic average return for the most risky stocks is at least keeping up with the broader market. However, these sharply negative returns in down markets led to the slightly negative long-run return. To illustrate these massive drawdowns for high-risk stocks, I have tabled the performance in negative years for the S&P 500 below. Just since the turn of the century, the most volatile stocks have had four annual returns of worse than -40%. These down years crush portfolio returns.

Source: Kenneth French, CRSP; S&P

Some high-risk stocks will see their business profile stabilize and their volatility will fall. Those stocks will exit the highest risk decile at the monthly rebalance point, presumably at higher prices. Some very high-risk stocks will leave the dataset because they will simply go out of business. The latter category seems to have outweighed the former. As past academic research has highlighted, the equity risk premium is attributable to a minority of stocks that have generated outsized returns. Over long time intervals, the median stock underperforms the market and the modal stock loses all its money.

A buy-and-hold trade that owns these higher risk stocks has lagged the market in every rolling ten-year period in this fifty-two year dataset. That is extraordinary. Even in extended bull markets like the one we are now experiencing, the highest risk stocks have not bested any of the other portfolios formed on trailing variance.

Source: Kenneth French, CRSP

It should be noted that in the rare instances that the highest variance decile has realized returns approaching any of the other deciles, it has been periods when the broad market is hitting record highs (e.g. 1999, current).

At the opposite end of the spectrum from the highest variance decile, the low variance deciles have been similarly consistent, but in a positive way. The three deciles based on the least volatile stocks have never produced a negative return over any ten-year period. Returns were low in the ten-year period ending in the stagflationary recession of 1974 and the period between 1999 and 2008 that featured the bursting of the Tech Bubble and the Global Financial Crisis, but they were positive.

For long-term investors spooked by seemingly stretched valuations and the risk of a potentially maturing business cycle, that is a pretty reassuring sign. For the last half century, buying low risk stocks has always generated a positive return over the course of a decade. This profile also included average annual returns that doubled an investor's money every seven years. Conversely, over long enough time periods, holding a portfolio of the riskiest stocks in the markets has never delivered market-beating returns.

With the rise of smart beta, investors now have a multitude of options to invest in low volatility factor tilts. The PowerShares S&P 500 Low Volatility ETF (NYSEARCA:SPLV) and the iShares Edge MSCI Min Vol USA ETF (NYSEARCA:USMV) are the most popular. The inverse of the Low Volatility fund is the PowerShares S&P 500 High Beta Portfolio (NYSEARCA:SPHB). We will revisit this article in ten years and see which one outperformed. For over forty years, the answer has been the same.

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 SPLV, SPY, USMV.

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.

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