18th May 2012
The risk and reward balance is why investors looking to maximise returns opt for bonds over cash, for equities over bonds, and for emerging market equities over those in developed markets or for small companies over large.
The risk and reward mantra
The higher risk, higher reward mantra is everywhere – from financial advisers to regulators, from pension funds to the £25 a month saver. It's taken with one's maternal milk – it makes apparent sense that a diversified portfolio of volatile assets will do better than a fund of low risk investments.
Investors have, according to countless theoretical and media sources, to be rewarded for knowingly taking on higher risks with higher returns. Otherwise, why would anyone bother. While the behaviour of equity markets since 2000 may give some reason to doubt, the conventional story is that this is an aberration which must one day return to normal service. And when it does, there will be the equity bull market to outdo all previous "stock market soars" stories.
Together they have turned the risk/reward paradigm on its head with a new paper with a clumsy title but an important message. Low Risk Stocks Outperform within all Observable Markets of the World hardly trips off the tongue but it is an essential antidote to decades of the Efficient Market Hypothesis and the closely related Capital Asset Pricing Model. These concepts persuaded investors to shift money in equity investments into capitalisation weighted indices such as the S&P 500 or the FTSE100.
Higher risks and lower returns
Wrong, wrong, and wrong, say Baker and Haugen. While they agree that equities return more than bonds over long periods, they rubbish the notion that more volatile or higher beta stocks do better than their most staid competition. Quoting academic papers back nearly 50 years, they claim that within the bond market and within the equity market, "the higher the risk, the lower the realised return".
A 2006 study finds US stocks with high volatility have "abnormally low returns" and a more recent paper claims a "minimum variance portfolio" provides the greatest Sharpe Ratio.
Baker and Haugen suggest that bearing risk in world equity markets – they consider 33 including developed and emerging – yields an "expected negative reward in all developed countries." This based on market data from 1990 to 2011 although this has been criticised as too short a period as it contained one decade of bull market and one of a long bear phase. Others contend the Baker and Haugen paper wrongly dismisses contrary findings as statistical anomalies.
But because they are taking on so much received wisdom, it is worth looking at their explanations. They ask: "Why do risky stocks sell at premium prices?" It is not, they suggest, because volatile stocks are likely to outperform in the future and some of that expected extra is in the price, or that the momentum that can cause risk drives stocks to better than average gains (partly in the price as well).
Fund manager pay drives portfolio choice
Instead the real explanation of this admitted "anomaly" lies in the "nature of manager compensation and agency issues (a) between professional investment managers within an organisation, and (b) between professionals and clients."
Managers paid a base salary plus a performance bonus can enhance this by opting for a high volatility portfolio even if this underperforms over time. This can be explained by the extra reward earned when the portfolio is rising is not returned to investors when it falls. A fund which rises 50% and then falls all the way back pays more than a lower risk portfolio which gains a steady 10% each year even though the latter would be better for investors.
The growth of the "two and twenty" remuneration model over the period of the study may be no coincidence.
Blame the investment committee
Investment committee meetings may also be to blame. As each member pitches stocks, there is a propensity to select compelling cases to impress colleagues rather than dull but worthy firms. These stocks tend to be newsworthy and with higher flow of new information – both factors producing higher risk.
Managers want a "story" to give to the media and financial advisers. This demand "overvalues the prices of volatile stocks and suppresses their future expected returns." Much the same applies to the equities recommended by broker analysts. All these factors serve to push up prices and lower returns. The conclusion is that the greater risk, greater reward theory is muddled.
"Existing textbooks are dramatically wrong and need to be rewritten," they say boldly.
Six textbook rewrites
Rewrite one: Don't invest in capitalisation weighted portfolios. Their performance is dominated by relatively volatile and over-valued growth stocks.
Rewrite two: Growth stocks are inflated by the expectation that their relative profitability will not be eroded by future competition. Take care.
Rewrite three: Beta – the measure of a stock's volatility against an index – is a relatively weak indicator and typically wrong.
Rewrite four: forget the efficient market hypothesis which says all securities are fairly priced. And the capital asset pricing model.
Rewrite five: Academics are human. Research may be influenced by the desire to preserve power and recognition so even wrong ideas are perpetuated so students pick them up and hence offer up greater prestige to
the original author.
Rewrite six: Practitioners research better than academics – not the other way round. The former have every reason to question the dominant paradigm – the latter have just as many reasons to defend it (as the source of their power and position).
For a brief paper, Baker and Haugen certainly put the cat among the pigeons. Investors can expect a flurry of refutations any time soon.
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