Report Questions Whether the Market Is Mispricing Risk; Supports Less Risky Stocks

(July 26, 2011) — New research by Russell Investments challenges the presumption that less risky stocks deliver lower returns.

“The standard theory of how markets work says that investors should only take extra risk if they think they are going to be compensated for doing so,” Bob Collie, chief research strategist, Americas Institutional, and one of the research authors, said in a statement. “But there’s scant evidence that riskier stocks systematically outperform their defensive counterparts.”

According to Russell’s research, the market fails to offer a premium to compensate investors who invest in riskier stocks as opposed to more stable (“defensive”) stocks.

Collie continued: “There’s good reason to believe that the widespread use of market-relative benchmarking by mutual funds and institutional investors is one contributing factor. That’s too entrenched and useful a practice for us to believe that it’s going to go away any time soon. So we may continue to see the defensive effect persist in the future.”

John Osborn, director of consulting and research co-author, explained in the release that if the market is mispricing risk, investors should create a better asset allocation to target the same expected return with lower risk, urging investors to rethink how they run their investment programs. “Overall, investors should pay more attention to risk when monitoring portfolio performance, and they should consider de-emphasizing tracking error as a risk measure and focusing instead on absolute risk,” he stated.

Such studies have increased in frequency since the financial crisis forced asset owners to reconsider the risk-return profile of their holdings. For example, in another analysis of risk, London-based portfolio manager with GMO argued this week that cash offers the best hedge against black swan events. A flexible allocation allowing timely moves into cash gives an asset owner the best tail-risk protection, the paper claimed. Institutional investors concerned about protection from black swan events often overlook the values of a flexible cash allocation, the paper argued. Other hedges like options/contingent claims and strategies that are negatively correlated with tail-risk simply do not provide the same level of protection.