Though popular momentum stocks get all the attention, low beta stocks have a greater potential for outperformance for long-term investors. Empirical studies underscore this fact.
So does our low beta stocks model portfolio. It outperformed the S&P 500 by a margin of 11% over the past year, returning 36%.
What is a Low Beta Stock?
A low-beta stock is one that exhibits lower volatility than the overall market, manifesting in a beta coefficient below one. A stock’s beta represents its sensitivity to stock market movements. A low beta indicates that the stock moves less than the market in either direction over a specific time period. Thus, these stocks can be considered less risky.
Examples of Stocks With a Low Beta Value
Stocks with a low beta tend to be considerably less well known than their high volatility counterparts who are the subject of all the media hype. Examples include H&R Block 📈 (HRB; Beta: 0.35), a DIY tax preparation service company, Enterprise Product Partners 📈 (EPD; Beta: 0.55), a leading gas pipeline company, or Arch Capital 📈 (ACGL; Beta: 0.53), a global insurance company.
The Opportunity in Low Volatility Stocks
The majority of investors strongly prefer high-beta stocks because they promise a chance at very high returns—even though the probability of success is fairly small. Making matters worse, individual investors tend to foot the bill when the market pulls back. We could see this play out once more over the coming months, as hedge funds have begun aggressively selling tech stocks this month.
The preference for volatile stocks creates an opportunity for long-term investors. The strong interest in high-beta stocks results in overpricing of high-beta stocks and underpricing of low-beta stocks. Over the long run, this produces higher future returns for low-beta stocks, as a number of empirical studies have shown.
What Are The Factors That Drive the Outperformance of Low-Beta Stocks
A combination of behavioral biases, market inefficiencies, and leverage constraints explains the outperformance of low-risk stocks relative to their high-beta counterparts. These factors contribute to the persistent outperformance of low-risk stocks.
Behavioral Bias
Investors collectively overreact to recent information and exhibit overconfidence in predicting future stock movements. When this happens, it drives up the prices of stocks with high betas beyond their fundamental values, meaning Lower beta stocks become undervalued.
Market Inefficiencies
Institutional investors and fund managers are focused on short-term performance to secure annual bonuses or hit certain business KPIs. Performance benchmarks can also lead to skewed portfolio allocations. These factors can result in neglect of low-volatility stocks that might offer better long-term returns, although they perform less spectacularly in the short run.
Leverage Constraints
Many institutional investors, such as mutual funds and pension funds, face leverage constraints and cannot borrow to invest in low beta stocks to achieve their desired level of portfolio risk. Instead, they over-allocate to high beta stocks to increase expected returns, which drives up the prices and suppresses their future returns, leading to better performance for low volatility stocks.
Empirical Research
In empirical research, the outperformance of low-volatility stocks is commonly referred to as the low-beta anomaly. This literature review by Joshua Traut is a great place to start reading up on the topic.
More specifically, research by Frazzini and Pedersen (2014) and others has shown that the performance of low-beta stocks can be partly explained by their exposure to other risk factors such as size, value, and quality. Low-beta stocks often have higher-quality attributes and lower valuations, which contribute to their superior performance.
The Advantages of Owning Low Volatility Stocks
There are two principal advantages for long-term stock investors.
First of all, thanks to relatively lower valuations, low-volatility stocks tend to drive portfolio returns, generating outperformance over the long run compared to the broader market.
Secondly, low-risk stocks provide stability to portfolios of risk-averse investors as they tend to exhibit lower volatility compared to the overall market. In practice, this means they experience smaller price fluctuations and are less susceptible to dramatic market swings. During market downturns, this is a highly valuable characteristic that can protect an investor’s portfolio.
How to Find Low Volatility Stocks
The best way to identify stocks with low betas is through a free stock screener. In addition to your typical screen settings, you should set a maximum threshold for beta risk. A maximum beta of 0.6 should give you an attractive opportunity for low-volatility stocks to work with.
The Case For Low Beta Stocks Is Clear
The outperformance of low-volatility stocks is empirical. Solid explanations exist – a combination of behavioral biases, market inefficiencies and leverage constraints. If you are looking to drive returns while minimizing risk, you should look for low beta stocks with great prospects. If you are looking for stocks to debate about at dinner parties, then your below the radar, low volatility stocks are unlikely to get you a lot of attention.
Important notice
This article is not to be understood as a recommendation to buy or sell. Please conduct your own research before making investment decisions. To this end, we aim to provide you with the best portfolio management tool and investment research data possible. However, we cannot guarantee the accuracy of this information in spite of our extensive efforts to ensure that the data is complete and 100% accurate.
Disclosure
Ziggma team members presently hold shares in one or several of the stocks mentioned in this article.