Which Investment ‘Style’ Will Give You The Best Returns?

A few days ago, MarketWatch featured an interesting research project titled “Wall Street’s Biggest Secret,” which showed some fascinating results. Let’s look at some highlights:

Wall Street has a wide array of mutual funds it wants to sell you. “Absolute return” this. “Midcap blend” that. “Small-cap growth” whatever.

Many brokers, advisers and salesmen will tell you that just the right mix of each one will give you a portfolio that’s “right for you,” with returns perfectly adjusted to your “risk tolerance.”

Phooey.

Before you invest a penny, listen to Bob Haugen.

He’s a former finance professor who’s spent half a lifetime studying the stock market. He’s written a number of books and papers, and is the co-author of remarkable piece of analysis entitled “Case Closed” and available here. Read the analysis .

He looked in excruciating detail at the characteristics of which stocks did best (and worst) over nearly half a century, from 1963 to 2007.

His finding?

Most of these “styles” are a waste of time. And the idea that you need to take on more “risk” to earn higher returns is a total con.

On the contrary, he says, the stock market has a big secret.

Over many decades, “the stocks with the highest risk produced the lowest returns — and stocks with the lowest risk produced the highest returns.” In other words, he says, “the risk/return ratio was upside down … the payoff to risk is consistently negative over the 45-year period of this study.”

Instead of being paid to take risk, you got paid not to.

All those glamorous, sexy ‘growth’ stocks? All that extra volatility you took on in the desperate pursuit of the next big thing? It was a bad move.

You would have done much better investing in the dull, low-risk, widow and orphan “value” stocks.

…

This has not just been true in the U.S., either. Haugen has also looked at historical data on the British stock market. On the Paris bourse. In Germany. In Japan.

The results were the same. Lower volatility stocks gave you higher returns. A free lunch.

There is much more to this story, so be sure click to on the above link. While most of this discussion centered on stocks, the same applies to mutual funds and ETFs.

The story did not elaborate on investment methodology, buy-and-hold or trend tracking, but the selection process applies to either. I agree with the fact that most of these “styles” do not add much value in the long term.

My (more limited) back testing efforts have shown similar results in that a slower growth ETF/mutual fund with less volatility will have its advantages over time, especially when bear market periods are included.

You can even see this clearly demonstrated in my weekly ETF Model Portfolios during the current market slide. While, during recent bullish periods (April), the S&P 500 inched ahead of the more conservative PRPFX fund, it also lost considerably more during the present pull back.

The numbers are pretty clear. As of last Wednesday’s post, the S&P 500 had gained +2.17% YTD vs. the PRPFX’s +5.48% although, at one point this year, the S&P had been ahead.

Looking at this entire buy cycle, which started on 6/3/09, the performances were as follows:

SPY (S&P 500): +37.13%

PRPFX: +38.45%

While the returns are very similar, the big difference lies in the volatility of the two. During that period, SPY has had a DrawDown of -16.07%, while PRPFX showed only -5.21%.

What that means is that as a disciplined investor with a trailing sell stop discipline, you would have experienced a whip-saw signal with SPY but not with PRPFX.

While whip-saws are a necessary evil to protect your portfolio from serious disasters, such as in 2000 and 2008, you also pay a price occasionally by looking for a new entry point, should a pullback turn out to be temporary in nature.

The story illustrates that low risk investments can produce the highest returns over time. When applied to trend tracking, the first lesson I have learned is that avoidance of a whipsaw, via the use of a low volatility ETF/mutual fund, can have a similar effect.

The second lesson I have learned is that avoiding a bear market, by being on the sidelines, keeps your portfolio not only intact, but also way ahead of everyone else’s.

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