âThe fact that low-risk stocks have higher expected returns is a remarkable anomaly. The study is persistent and comprehensive, contradicting the very core of finance,â says Mr Haugen.
Between 1990 and 2011, the least volatile decile of developed nationsâ stocks generated average annualised total returns of 8.7 per cent, while the most volatile lost 8.8 per cent a year.
Narrowing the focus to US equities, the research shows the least volatile decile made average returns of 12 per cent over the same period and the most volatile lost 7 per cent.
âIn every country of the world, risk and return are upside down,â argues Mr Haugen, a proponent of the theory that equity markets are inefficient.
But not everyone is convinced by the findings. Antti Ilmanen, managing director of AQR Capital Management and author of a book called Expected Returns, suggests a 21-year period of testing is relatively short, pointing to a clutch of existing studies on the topic extending over longer periods, a view shared by Elroy Dimson, finance professor at London Business School.
Mr Dimson points out âthe 21 years were a period of disappointment in world equity markets,â with stocks underperforming bonds by 2.4 percentage points a year. He refers to a broader study â Betting Against Beta â by Andrea Frazzini and Lasse Hele Pedersen, in 2011, which looked at equity markets, government and corporate bonds and futures.
There is also healthy debate on the performance of low-risk stocks. âI donât think you can say low-risk stocks always outperform high-risk stocks. It is too limited a view,â says Fiona Frick, chief executive of Unigestion and chair of the Swiss asset managerâs minimum variance committee.
However she says âit is true in some kinds of environment such as volatile markets where corrections occur but in bull markets high-risk equities tend to outperform [low-risk ones].â
She believes it is important to add other factors on top of a low risk, low volatility approach such as âfundamental information about the companyâ.
In constructing its minimum variance equity portfolios, Unigestion prefers to look at a wider mix of diversified companies than just low risk, low volatility stocks âlike choosing different kinds of players in a football team,â adds Ms Frick.
Mr Ilmanen takes a slightly different view of the research. He believes low-risk stocks outperform high-risk stocks on a risk-adjusted basis âbut if you look at [comparative] absolute returns then that is flat,â he says. Nonetheless he sees the appeal of such a strategy. âIf you can get at least the same returns as investing in riskier stocks then this is attractive.â
âPeople get well rewarded for taking small risks, such as buying defensive stocks or extending maturities in the money market, but taking further risks is poorly rewarded in the long run.â
So why are people exposed to high risk/high volatility stocks in the face of such evidence?
According to Mr Haugen âprofessional investors were persuaded to move trillions of dollars in equity investments into market capitalisation-weighted equity indices such as the S&P 500,â largely because they were influenced by earlier concepts of market efficiency, such as the efficient market hypothesis.
Mr Ilmanen says many traditional long-only fund managers are more concerned about their tracking error versus the benchmark than about total portfolio volatility. âDefensive investments reduce portfolio volatility but raise its tracking error risk, so many managers say âno thanksâ,â he argues.
This may help to explain why investors are not piling into low-risk stocks although there are signs of a shift. âFor the first time in my career I am seeing significant interest in low risk/low volatility stocks, including [from] pension funds,â says Mr Baker.
Consultants are also starting to play a part in driving a shift to low-risk strategies particularly in the UK, Europe and Asia, according to Mr Haugen.
While investors are not piling in yet, it is a good time to benefit before prices are pushed up, argues Mr Baker.
âFor returns to fall, there will have to be a very large price adjustment, then low-risk stocks will be on a par with high-risk but this will take 10-20 years,â he says.
Mr Ilmanen also identifies a change of strategy but only among a minority of investors âWe do see some investors moving into a low volatility strategy but most still like more active, risky, speculative investments,â he says.
He believes the same stocks will do well again as investors are likely âto behave the same way in the future. It worked in the past 20 years and I feel confident it will work in the next couple of decadesâ.
However he is quick to point out that low-risk stocks did not fare well in the âjunkâ rally of 2009. âNothing works all the time,â he adds.
