Traditional finance rests on the theory that risk is rewarded with higher average returns. At the asset class level, there is some support for this idea. Stocks are riskier than bonds and have generally provided investors with higher returns, presumably to compensate for this extra risk. However, it may surprise many investors to learn that over the past 40 years portfolios comprised of high-risk stocks have substantially underperformed their lower-risk counterparts. This anomaly offers intriguing potential investment opportunities. If risk is not rewarded, why hold risk? Acadian's managed volatility strategies focus on exploiting this mispricing and have the potential to allow investors to achieve similar, or better, returns than capitalization weighted indices with substantially lower risk.
In an efficient market, economic theory suggests that high risk stocks should realize higher average returns than low risk stocks. However, this theory has been difficult to observe in the history of U.S. stock returns. The most widely used measures of risk, volatility and beta, show no relationship between risk and return. In fact, they suggest that the relationship between risk and return may even be negative
The long-term success of low-risk stocks may well be the greatest anomaly in finance. It challenges the basic notion of a risk-return trade-off. Acadian examines this mispricing from a behavioral finance perspective and hypothesizes two drivers of these results: a well documented irrational preference for high risk stocks, and underappreciated limits on arbitrage stemming from the central role that benchmarks play in our industry.
An irrational appetite for high volatility stocks may originate from several behavioral tendencies that afflict individual investors. We believe the individual preferences for lotteries and the well established biases of representativeness and overconfidence lead to excess demand for high risk stocks which is not justified by fundamentals.
Additionally, the investment management industry's fixation on capitalization weighted benchmarks poses a barrier that may limit arbitrage opportunities. Because of the prevalence of the Information Ratio (benchmark-relative return divided by benchmark-relative risk) as a tool to measure manager skill, managers are incentivized to invest in stocks with close-to-market risk, i.e. beta near 1. The result is that asset managers tied to capitalization weighted benchmarks are more likely to pass up opportunities in low risk stocks in favor of stocks with market-like risks, but higher expected returns.
Most active equity managers have historically focused on the search for stocks that have average risk characteristics and are expected to produce better than average returns. Simple value and momentum strategies fall into this category. Managed volatility strategies are another form of active management. They aim to deliver market-like returns for substantially less risk than the overall equity market and exploit a mispricing of risk.
A variety of approaches may capture the underlying mispricing of risk. Acadian focuses on low total portfolio risk when building low risk portfolios. This choice puts the emphasis on choosing stocks with low systematic risks (low beta) and, to a lesser extent, on stocks with low total risk. The primary difference between a low risk portfolio and a portfolio of low risk stocks is that the correlation between stocks influences the buy and sell decisions of the former, but not the latter. The low risk portfolio approach produces a portfolio of low risk stocks with low correlations to each other. This is expected to produce a lower risk portfolio than simple sorting based approaches.
Our managed volatility portfolios take the low volatility concept a step further by adding a small but persistent exposure to Acadian’s return forecasts. Once transaction costs, liquidity and certain prudent constraints are considered, a manager can choose from many portfolios with approximately the same risk characteristics. Acadian’s managed volatility approach chooses the portfolio with the highest expected return among all of these low risk candidates, resulting in portfolios which we believe could achieve a modest and consistent exposure to different return sources.