Do higher expected returns demand higher risk? This relationship does not always hold true, as defensively positioned portfolios of high dividend and high quality stocks demonstrate.

Minimising risk pays off because 1% loss cannot be offset by 1% gain

One could argue that an investment's downturns are only relevant when losses have to be realized as book losses can, at least in theory, always be recovered. However, percentage-wise, the up- and downside risks are not symmetrical. If an investor who starts with USD 100 loses 20%, his assets amount to USD 80. In order to recover his loss and get from USD 80 back to USD 100, he'll need a gain of 25%. For this reason, minimizing downside risk can pay off in the long term.

Asymmetric up- and downside risks

Normally, higher risk leads to higher expected returns – that does not apply for stocks

It is a generally accepted presumption that a positive relationship exists between risk and expected return. A rational investor would only buy a risky asset class if he anticipated getting compensated for the higher risk by receiving a higher return. Bonds of high creditworthiness therefore have lower expected returns than, for instance, junk bonds or equities.

Within equities, however, this relationship does not hold true. Academic studies suggest that in the long term, stocks with the lowest risk outperform stocks with the highest risk. In the US equity universe the 20% stocks with the lowest volatility outperformed the 20% stocks with the highest volatility by 7% annually over the course of 40 years until 2008. The study covering a global equities universe is about 20 years shorter, but comes to a very similar conclusion.

Defensive equity investing added value in the US…

Empirical evidence (1968-2008)

Average annual outperformance for US equity universe

Click on image to enlarge. Source: Baker, M., Bradley, B. and Wurgler, J (2011) Benchmarks as Limits to Arbitrage: Understanding the Low-Volatility Anomaly. Financial Analysts Journal 67 (1), p. 48.

…and also globally

Empirical evidence (1986-2006)

Average annual outperformance for global equity universe
 

Click on image to enlarge. Source: ERIM Report Series Research in Management "The Volatility Effect: Lower Risk without Lower Return" by Blitz/van Vliet (April 2007)

The fact that stocks with lower risk perform better in the long run than stocks with higher risk could be caused by irrational investor behavior. A significant part of the investment community are willing to pay too much for cyclical stocks in the hope of capturing the maximum upside. Those investors may shun less cyclical stocks because they perceive them to have less imminent upside which can render said stocks comparably cheap. This can be exploited by rational investors.

Conclusion for investors: Defensive equity portfolios should generate better risk-adjusted returns in the long run

As outlined in the previous paragraphs, investors are well advised to consider defensive quality-oriented stocks if they seek equity exposure. UBS Asset Management's range of Equity Income strategies offers investors solutions that mitigate some of the downside in bear-market environments, aiming to provide attractive risk-adjusted returns. Moreover, they generate income from various sources including dividends and the sale of call options, and in case of the US strategy, share buybacks also.

Urs Raebsamen, Senior Equity Specialist