One of the central tenets of finance has been that investors should be compensated with higher returns for higher levels of risk. Rational investors should not accept the same or lower levels of return for similar levels of risk.
This relationship is encapsulated in the Capital Asset Pricing Model - one of the central tenets of modern finance - depicted in the simple chart below:
At an industry level, Utilities (XLU), owing to the regulated nature of their returns, have historically been less risky than Industrials (XLI). Consumer Staples (XLP) are less exposed to the finicky preferences of consumers than Consumer Discretionary stocks (XLY). Healthcare (XLV) has seen less industry transformation than Technology (XLK). One would expect then that the higher risk industries have delivered higher returns.
Over the last generation, the relationship between the risk and return of market sectors has had a very different look. Below I have graphed the actual returns and realized volatility of the Sector SPDR ETFs, a collection of exchange-traded funds that allow investors to make targeted low cost sector bests. The relationship between risk and reward of these sectors has been negative over a period stretching back over two decades. Higher risk industries have produced lower returns, and lower risk industries have produced higher returns. The slope of the line in the graph below is the opposite of the stylized version above.
On Seeking Alpha, I have written extensively about the Low Volatility Anomaly. It is one of my "5 Ways to Beat the Market" and I have recounted academic research that shows Warren Buffett's Berkshire Hathaway (BRK.A, BRK.B) owes much of his success to capturing the Low Volatility Anomaly financed by low cost leverage. I have shown that the success of low volatility stocks has extended over many decades and that low volatility stocks have always generated positive returns over rolling ten-year periods. I have shown that a low volatility tilt has also worked in small-cap stocks (NYSEARCA:XSLV), mid-cap stocks (NYSEARCA:XMLV), large cap stocks (SPLV, USMV), emerging market stocks (EEMV), and high yield bonds.
How do you test if an investment strategy works? You examine it over different market environments, geographies, asset classes, and market subsectors. This article covers the latter test. The low volatility anomaly has existed across industries over the trailing generation.
The four lagging higher-risk industries - financials, technology, energy, and materials - have all faced unique pressures over this time horizon. Financials have been hamstrung by the Global Financial Crisis and the low-rate environment post-crisis. Technology stocks were hurt by the Tech Bubble early in the sample period. Energy and Materials stocks have been hurt more recently by the drawdown of commodity prices in 2015 and 2016. These industries have faced stress, which led to lower and more variable returns.
Has the relationship between risk and return at the industry-level been a function of this sector-based stress? Or does rolling sector-based stress simply lead to this departure from CAPM, and we should expect lower volatility industries to outperform over time? It is difficult to wait for another out-of-sample two decade period to strengthen your conviction on low volatility industries and stocks.
I think this argument, which demonstrates the negative relationship between risk and return at the industry-level, further strengthens the structural case for low volatility stocks over long time intervals. Of course, as I wrote on Monday in Rolling Returns of Low Volatility Strategies, there will be periods where Low Volatility stocks underperform. We are currently in a period where Low Volatility stocks have handsomely bested the broad market over the past year. This article makes the case for a strategic overweight to low volatility stocks, buoyed by this historical relationship between risk and return at an industry-level, and not a tactical one. As long-time readers know, I have been structurally long low volatility stocks with modest amounts of investment leverage (a more effective way of increasing your risk profile than simply buying suboptimal risky stocks and sectors). Into this rally for low volatility stocks, I am letting net cash flow de-lever my investment portfolio, and not looking to add to the position further.
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,USMV,SPY,XMLV,XSLV,EEMV. 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.