Finding Higher Returns With Lower Risk

Investors have seen firsthand what damage volatility can do to portfolios, and nerves, as market swings have taken them on a wild ride. While Wall Street's "fear gauge," the Chicago Board Options Exchange Volatility Index, recently dropped to a low not seen since before Lehman Brothers declared bankruptcy in September, risk levels remain far above average. "Volatility is off the crisis extremes, but from a historical standpoint it's still at elevated levels," says Wasif Latif, assistant vice-president for equity investments at USAA Investment Management.

Many investors figure they'll have to take on more risk, even now, to recoup losses. But that may not be the case. In this era of above-average volatility, with short-term market swings far more rapid and extreme than the historic norm, there are more ways than ever to guard a portfolio against risk, or to use it to one's advantage.


Opting for lower risk doesn't necessarily mean accepting lower returns, says Harindra de Silva, president of investment management firm Analytic Investors in Los Angeles. Two years before this fall's drama unfolded, a paper he co-published came to that conclusion, and also found that low-volatility portfolios can outperform the market. From 1968 through 2005, a portfolio with less risk beat the overall market by an average 0.9 percentage points a year. Surging interest in low-volatility strategies among institutional investors prompted MSCI Barra to develop a series of indexes to which investors can compare their portfolios. Frank Nielsen, executive director of index research at MSCI Barra, explains that though low-volatility stocks tend to underperform the market in big rallies, they make up for it during bear periods.

Launched in April 2008, MSCI's U.S.A. Minimum Volatility Index is down -26% over the past year, vs. -34% for the Standard & Poor's 500-stock index. Nielsen says that exchange-traded funds that track MSCI's low-risk products are in the works. And in May, Standard & Poor's (like BusinessWeek, a unit of The McGraw-Hill Companies (MHP)) launched a "risk-controlled version" of the S&P 500, which targets a volatility level of 10%. If the volatility on the S&P 500 tops 10%, some money is allocated to cash; it also adjusts if volatility falls below 10%.

Products like these aren't the only way to handle volatility. Many fund managers build low-risk portfolios. Morningstar (MORN) rates funds based on how volatile they are relative to their own and peers' history. A not-so-surprising fact: Low-risk funds overall have better records than riskier peers over one-, three-, five-, and 10-year periods (table).


Investors also can make volatility work for them. Paying more attention to their investment mix is a start. In calmer days, investors could rebalance portfolios once a quarter or once a year. Now that might not be enough. Take the recent move in financial stocks. The sector has nearly doubled since its March low, while the broad market gained 35%. Investors who may have wanted 10% of their portfolio in financials found themselves with a 15% stake in just a matter of weeks.

In fact, forget holding for the long term, says Blaze Tankersley, a managing director at investment banking firm Bay Crest Partners. Instead, investors should think about the kind of return they expect from a long-term investment and use that to decide when to sell. If you expect 10% a year for five years, selling a stock after a 50% move might make sense. David Ellison, manager of the FBR Large and Small Cap Financial services funds, would prefer to hold long-term, but his favored metric, the price of a stock relative to the company's value if it were liquidated (book value), hasn't let him. Financial stocks have moved too quickly from his buy range, which is around half of book value, to his sell range, someplace between one and three times book value. "The industry would like you to hold a stock forever," Ellison says. "But if it goes up 80% in one week, it's like, 'Hello?' "

Since managing a portfolio can be time-consuming, investors may want to use limit orders to set buy and sell prices ahead of time, says Charles Zhang, a financial adviser with Zhang Financial in Portage, Mich. As bank stocks recovered recently, Zhang placed limit orders to buy shares if prices fell 10%, and to sell, say, half a position if prices rose 20%. The same technique would work for investors who use ETFs to build a portfolio.

Frequent trading means higher costs, however, and taxes are an issue. Short-term gains are taxed at ordinary income tax rates, vs. 15% on stocks held for at least a year. So investors shouldn't be afraid to sell losers to offset winners, says Oak Funds portfolio manager Robert Stimpson.

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