Of all the experts that we would expect to undermine the basis of passive (index) investing, Standard and Poor’s, the creator of the widely-followed S&P 500 Index, was not high on our list. However, in a recent piece The Low-Volatility Effect: A Comprehensive Look, the company inadvertently does just that. The paper is a review of the mountains of academic and industry literature that has emerged bucking some of the widely-held beliefs of Modern Portfolio Theory, including the premise that investors get paid for taking more risk (see our January 2012 commentary on the subject in our article What Color Is Your Parachute?). S&P concludes,
“. . . low-risk investing outperforms the broad market as well as high-risk strategies over a long-term investment horizon with much less realized volatility.”
Damning as this may be for the index approach – the epitome of market volatility – we believe indexing can at times still offer a cheap and tax-efficient way to capture market returns. As professional investors and fiduciaries, however, it is a single tool in a broader tool kit to maximize risk-adjusted returns, and not the one-size-fits-all hammer often wholesomely sold to main street investors.
The gist of the research is that market volatility has been a powerful enemy of long-term performance. The relationship has held in various asset classes and across geographies. The lower volatility approach invariably has delivered higher returns with anywhere from one-half to two-thirds the risk when compared to the broad market index. While the S&P study cited data going back 20 years, other studies have found a similar relationship going back more than 80 years. . .