Even newcomers to the world of investing know that there is a direct relationship between risk and return. This is expressed for instance by such sayings as "No risk, no reward," and "You’ve got to speculate to accumulate." I doubt that many investors question these assumptions; it is by now pretty much a no-brainer that if you want higher returns, you have to accept higher levels of risk.
There is certainly no lack of support for this view among the good and the great of the academic community. Over more than fifty years, the risk-return concept has been tested by hordes of academics all over the world, so that by now a mountain of evidence has been gathered to confirm the positive link between risk and return.
However, perhaps surprisingly, not all academics and practitioners have leapt aboard this bandwagon. For example, one Robert Haugen has said: "Although ...there is a mountain of evidence supporting this hypothesis, the truth of the matter is that it’s a very old mountain that’s now eroding rapidly into the sea."
Low risk and high returns?
In terms of risk and return, Haugen believes that the conventional wisdom is seriously flawed. In fact, he believes that low risk (defensive) shares have, over time and across all of the world’s major stock markets, outperformed high risk shares. Haugen also has the research to support his contention, the most recent of which was published just a couple of months ago. And yes, he did include the JSE in his research, and found that the same low risk, high reward phenomenon prevails on our stock market.
One might be tempted to laugh Haugen off as a crackpot who is obviously a few sandwiches short of a picnic. This would be a mistake, however. While not one of the household names of the investing world, he is nevertheless not short on credentials. He has held professorships in finance at the universities of Wisconsin, Illinois and California, and is the 17th most prolific researcher in finance based on the number of articles he has had published in top financial journals.
More significantly, perhaps, is the fact that he left academia to put his ideas into practice. He is now president of Haugen Custom Financial Systems, and has from all accounts achieved considerable success with his own "Expected Return Factor Model." Haugen acknowledges that the theories of modern finance are elegant theories, but aptly points out that "in real-world finance they don’t pay for elegance, they pay for power - predictive power."
Modern finance and the risk–reward relationship
Before we look at Haugen’s research in more detail, and consider why it might be valid and how it could be of value to us, we need to take a quick look at the theories of modern finance and their view of the risk–reward relationship.
The link between risk and return in share markets was formalised during the 1960’s and early 1970’s, when what is known as Modern Finance was coming into fashion. The basic concepts underpinning this new view of markets were the Capital Asset Pricing Model (CAPM), and the Efficient Markets Hypothesis (EMH).
The CAPM tells us that there is a general return we can expect from a share market as a whole, based on a risk-free return (e.g. the return on a ten-year government bond), plus a premium for the market risk we are taking on. Measured over many years in the world’s biggest stock markets, this premium has been found to average between around 5% and 7%. So, if the risk free rate is 7% on a ten-year SA government bond, and the market premium on the JSE is 6%, an investor in a JSE All Share index fund could expect an annual return of (7% + 6%), i.e. 13%.
According to Modern Finance Theory, it is possible to get a higher return from individual shares than from the market as a whole. However, this is only possible by taking on extra risk, which is measured by a share’s "beta." Beta measures volatility, i.e. the extent to which a particular share’s price moves in relation to the movement of the market as a whole.
So, if the stock market as a whole increases or decreases in value by 5%, and during the same period the share price increases and decreases in value by 10%, that share would be said to have a beta of 2. The implication would be that the return expected from that share would be (referring to our CAPM example above), [7% + (2 x 6%)] = 19%. So, because the share is regarded as being twice as volatile (i.e. risky) as the market as a whole, in considering the required return from that share we must multiply the market premium by a factor of 2.
Support from the efficient markets hypothesis
The supporting leg to this theory is provided by the EMH, which maintains that, in efficient markets, all publicly available information relating to a share (and its underlying company) is available to all interested parties at the same time. (The only exception to this rule is insider information, but because of general sanctions taken by markets against insider trading, this is not regarded as being a problem).
What this implies is that new information about a share is immediately taken up in the share price. As a result, stock market prices accurately reflect the risk associated with each share. Because of this informational efficiency, shares are in turn are accurately priced; there is no way for someone to buy a share at a bargain price because of information known only to them. As a result, the majority of investors and fund managers do not manage to beat the market (when risk is taken into account), and for this reason an investment in an index-based tracker fund is often recommended.
Of course, as we can see by applying the CAPM, shares with low betas and therefore low volatility are not expected to produce a high return. Per our CAPM example above, a share with a beta of 0.5 would be expected to return [7% + (0.5 x 6%)] = 10%, quite a bit lower than its riskier counterpart with a beta of 2. And this is where we return to Haugen and his research, because he (and a colleague named Nardin Baker from Guggenheim Investments) investigated the returns from defensive and volatile shares, and came up with some surprising results.
Haugen and Baker’s research
Haugen and Baker gathered data from the stock markets of 21 developed countries and 12 developing nations (including SA). In respect of each country’s stock market they sorted all of the quoted shares into ten groups, based on their monthly volatility in the previous two years. They then ranked these groups, from the most volatile to the least.
The two researchers found that the least volatile group of shares in each market outperformed the most volatile group between January 1990 and December 2011. This was true for every one of the 33 markets they looked at, and except for the three-year periods 1997 to 1999, and 2004 to 2006, was also true for every three-year sub-period of those 21 years. Over the full 21-year period on the JSE, the researchers found that the low-risk portfolio outperformed the high-risk portfolio by 10.5 percentage points.
The question that arises is why this should be so? Logically one would expect a greater return from taking on more risk, but it seems that in pursuit of these higher returns, investors across the world are overpaying for risky shares. Haugen and Baker have come up with two possible explanations for this behaviour.
The phenomenon explained
In the first instance they explain that institutional investment managers are often remunerated on a salary-plus-bonus scheme, with the bonus being based on achieving a certain level of performance (i.e. growth in the value of the shares they have purchased).
Now, while defensive shares in Haugen and Baker’s study beat the more volatile shares over most three-year periods, it is more likely that volatile shares could prevail over shorter periods. So, as investment managers receive annual bonuses, they might believe that volatile shares are more likely to help in this regard by providing short-term growth. High levels of institutional demand have therefore driven up the price of volatile shares.
The second explanation advanced by Haugen and Baker is based on the way in which investment managers build individual portfolios for clients. Investment firms typically hold periodic investment committee meetings, where a team of investment analysts sits before the Chief Investment Officer (CIO). Each analyst is expected to make a case for shares they believe should be included in the model portfolio.
As the analysts want to impress the CIO and the rest of their peer group, they are attracted to shares for which they can make a compelling case. These shares tend to be noteworthy, and are often the centre of media attention. As a result, they are easier to "sell" to both the CIO and future clients. They also, however, often exhibit higher than average volatility. So, as in the case of institutional buyers looking after their bonuses, demand by investment firms tends to overvalue the prices of volatile shares and drive down their future returns.
Haugen and Baker found support for the above-mentioned theories after studying the holding of, and the media attention around, the 100 largest shares in the USA between 2000 and 2011. They discovered the following:
- Financial institutions hold more volatile shares
- Analysts cover is significantly greater for more volatile shares
- News coverage is more intense for more volatile stocks
Implications for investors
The research by Haugen and Baker has implications for serious investors, who should consider the following:
- Advice to invest in an all-share tracker or index fund may not be the best way to manage the risk-reward trade-off. A portfolio of low-beta shares may be preferable, and could provide better long-term returns.
- While volatile shares may provide better short-term returns at times, in the longer run the winners are the defensive shares. Remember the old saying: It’s not timing the market that counts, but time in the market.
- Haugen and Baker’s research does not appear to have considered dividends when calculating returns. As less volatile blue chip shares often pay better and more regular dividends than their more volatile counterparts, this could be a further benefit of investing in defensive shares.
- Remember that price is always important. Buying defensive shares at the top of a bull market might mean waiting a very long time for those improved returns.
- By the same token, when bears are prowling the markets that could be the ideal time to search for bargains among the duller, less-volatile shares.
Researchers such as Haugen and Baker are asking us to reconsider some of our most cherished investing beliefs. As strange as it may seem, fortune does not seem to favour the bold investor.
While "fortune favours the cautious" doesn’t have quite the same ring to it, defensive investing may just be the way to go if you’re looking for better returns in the long run.
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