They're correlated, but not in the way many investors think.
To generate better returns, investors should take on more risk, right? The answer may seem obvious, but historically, it's depended on what the meaning of the word "risk" is.
In an absolute sense, it's of course true that the more money investors put at risk, the more they'll gain if their investments increase in value. However, with the kind of risk that's become synonymous with volatility in investment argot, the opposite has been true. On average, high-beta investments--those whose prices have swung wider than an index over a given period of time--have historically generated worse returns than less-volatile alternatives.
The pattern has been persistent. This study, which appeared last year in the CFA Institute's Financial Analysts Journal, found that between 1968 and 2008, a portfolio comprising the least-volatile quintile of the market's 1000 largest stocks swamped the most-volatile quintile over the course of 40 years. And in this explanation of why boring can be beautiful, Morningstar ETF analyst Samuel Lee cites the work of Lasse Pedersen and Andrea Frazzini. In this 2011 paper, the duo find better risk-adjusted returns resulting from "betting against beta" across a broad range of asset types and geographic boundaries over a 50-year time frame.
History doesn't always repeat. Over a lengthy stretch of time, though, investors have fared better by taking on less risk, not more.
Beta and standard deviation are widely adopted gauges of volatility, but for most fund investors, Morningstar Risk and the Sortino ratio are arguably more relevant. Few investors fret over oxymoronic "upside risk," after all, yet beta and standard deviation are agnostic when it comes to assessing upside versus downside volatility. Not so Morningstar Risk and the Sortino ratio, each of which (although in different ways) penalizes downside performance gyrations. The wilder the ride has been amid losses, the poorer a fund's Morningstar Risk Rating and Sortino ratio will be.
For this article, I examined a subset of domestic-equity funds to see if, after substituting Morningstar Risk for beta, the historical data would continue to show a low-volatility premium. To be included in the subset, a fund needed a track record of at least 10 years as of January 2012, a requirement that resulted in a group of roughly 1,700 funds. In addition to these funds' annualized 10-year trailing returns, I reviewed their percentile category rank for both total return and Morningstar Risk. Sorting the funds according to the latter data point controlled for style, allowing for analysis across risk groups comprising the least to most risky funds in each of Morningstar's domestic-equity categories.
After segmenting the funds into quartiles, here's what I found.