Active Equities Don’t Have to Be Riskier
May 18, 2015
Many investors are throwing in the towel on active equity management in the name of evading risk. But being active doesn’t always mean accepting higher risk. Consider, for instance, the benefits of even-tempered stocks.
Skimpy bond yields and booming equity markets have investors wondering where they are going to get the returns they need to meet long-term obligations. After the bull run of the past six years, equities aren’t expected to pack the same return wallop, so passive approaches aren’t likely to be enough. That means equity allocations will have to work harder.
Yes, There Is Alpha in Stability
The key to capturing alpha in equities is to stand out from the crowd. You can do this by leaning on the higher-risk, higher-return potential in smaller-cap and lowly valued stocks or by following short-term price trends, for example. But, surprisingly, you can also generate alpha by taking less risk versus the market.
That may sound counterintuitive. After all, traditional financial theory teaches that risk and return go hand in hand: accept higher volatility and you’ll get paid higher returns over time. But academic research and actual experience tells a different story (Display, left side). Steadier stocks typically don’t fall as much as stocks do generally in downturns, so they tend to preserve more of their gains—and even outperform—over full market cycles.
Measured in units of absolute risk (or what the industry calls the Sharpe ratio), long-term returns of less volatile stocks have been on a par or better than more aggressive equity strategies over four decades (Display, right side). So, by this measure, an equity strategy that returns as much as the market, but with two-thirds the volatility, delivers 50% more return per unit of risk.
Okay, So What?
You may reasonably ask: same dollar amount but lower risk—what good does that do? In a total portfolio, however, that risk reduction can be used in many return-enhancing ways:
•To allow a shift from bonds into higher-returning equities
•To pair with an allocation into more aggressive yet higher-return equity strategies
Either way, the portfolio gets higher return potential without adding to overall risk (Display). And because of this lower absolute risk, we believe a portfolio of even-tempered stocks is a more efficient way to access the extra return of equities than passive, cap-weighted approaches.
Countercyclical Behavior Is Another Plus
This “stability alpha” can be tapped in many ways. Typically, it is found in companies that enjoy durable competitive advantages such as a proprietary technology, a well-defended network effect, a beloved brand or a favorable regulatory or secular-growth dynamics. They are good stewards of capital, and often less influenced by economic cycles than the market generally.
Because of the counterbalancing nature, these portfolios tend to perform best when other active approaches are less effective. As a result, they offer strong diversifying benefits that can be used as a source of uncorrelated alpha on its own or as part of a risk-management plan.
Finally, by providing more stability, we believe these strategies can improve the chances of securing the long-term equity returns that investors want and need. Given where we are in the investment and rate cycle, a smoother journey that’s easier on the nerves can help keep investors on course when turbulence strikes.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. MSCI makes no express or implied warranties or representations, and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed or produced by MSCI.