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What’s the best way to lower volatility?

There are many kinds of investors, but I’ve never met any who enjoy volatility. Unfortunately, since the early summer the volatility of the stock markets have picked up. This recent bout of volatility is not much different from historical norms, but that doesn’t make it any easier to stomach.

We shouldn’t be surprised that investors are looking for ways to lower volatility in their investment portfolios—but, of course, they don’t want to sacrifice returns. But isn’t risk and return two sides of the same coin? Lower volatility and high returns sounds like a free lunch.

Certainly there are money managers who claim they can capture the returns of the broad equity markets while travelling a smoother road. These so-called “equity minimum-risk” or “minimum variance” strategies have been around for about 20 years, and given the current climate, they’re making a resurgence.

This year we’ve seen the launch of several exchange-traded funds (ETFs) with low-volatility strategies. In general, the managers screen for stocks with low beta—in other words, those that are least sensitive to the movements of the overall market. These stocks are often weighted in the fund according to beta, rather than by market capitalization. The idea is to create a portfolio with a higher return-to-risk ratio than the benchmark index.

The purveyors of these funds often argue that low-volatility strategies do not involve a trade-off. “The risk is lower but you can still get equity-like returns,” one manager said in a popular newspaper last month. He went on to state that since the beginning of 2000, his strategy outperformed the market by more than 5% while enjoying 35% less volatility.

Science Meets Intuition

Intuitively, low-volatility strategies make a lot of sense. But an investment strategy needs to be based on science, not intuition. Science involves rigorously testing an idea using large amounts of data—not one 12-year period with a carefully selected start date.

As it happens, Dimensional Fund Advisors recently published a study examining low-volatility strategies. They used more than 40 years of data, covering 1968 through 2010. The study found that a low-beta strategy would indeed have produced slightly better returns than the overall market, with significantly lower volatility. But that wasn’t the whole story.

The paper revealed some other interesting findings. First, while the low-beta strategy delivered significantly better risk-adjusted returns from 1968 to 1989, it underperformed over the next 22 years of the sample. As with many strategies that appear to be a free lunch, you often get handed a large bill at the end.

Second, low-volatility strategies seem to trade market risk for value risk. In other words, investors would have obtained very similar risk-adjusted performance by giving more weight to stocks with value characteristics (those with a low price compared to book value, earnings or dividend yield) rather than those with low beta.

The Better Way

Finally—and most important of all—the DFA study demonstrated that there is a better way to lower volatility in a portfolio. It’s the two-part strategy I use with my clients. First, rather than trying to lower the volatility of a investment portfolio by selecting low-beta stocks, it is more efficient to do so by increasing exposure to high-quality bonds. Second, the strategy maximizes the returns of the stock part of the portfolio by focusing economic factors (such as size or valuations) with higher expected returns.

According to the DFA study, over the last four decades a simple 50/50 blend of high-quality bonds and value stocks had a higher Sharpe ratio (a measure of risk-adjusted returns) than a strategy that relied on selecting low-beta stocks. “The equity portion of this portfolio targets higher expected returns through exposure to value stocks,” the study’s author explained, “while the fixed income portion lowers volatility and provides diversification benefits.” Simply put, this combination is the best way to maximize risk-adjusted returns.

Low volatility, buying defensive stocks, investing for yield—the investment world is full of investment strategies that sound intuitively appealing. However, the evidence is that these strategies simply don’t live up to their promise.