Risk/Return Relationship
Several years of extensive research has helped formulate the firm’s belief that low volatility stocks have higher risk-adjusted returns. Freeman believes that while most of the equity market, as defined by the Russell 3000 Index, is efficiently priced, about one-third is not.
The inefficiently priced portion of the market comprises the more speculative end, where investors are rarely, if ever, adequately compensated for the risk accompanying the most volatile stocks.
This graph shows that the relationship between risk and return is profoundly disappointing. It shows the Russell 3000 Index sorted into deciles by volatility with returns and volatility calculated from January of 1979 through December of 2008. Contrary to the views widely held in academic finance and among institutional practitioners, the firm’s evidence contradicts popular theories like the Capital Asset Pricing Model (CAPM) and Efficient Market Hypothesis, both of which contend that a strong positive relationship exists between risk and return. Freeman believes that sustained levels of volatility are generally accompanied by very poor sustained returns.