Monday, October 03, 2011

Regarding Low Volatility Stock Portfolios

Saturday's edition of the Wall Street Journal contained a long, prominent article extolling the virtues of so-called low-volatility equity portfolios entitled, somewhat immodestly, Beat the Market- With Less Risk.

It's a piece that runs the equivalent of a full Journal page. Suffice to say, the title makes the major claim. Never mind that risk, which is what the piece claims is minimized, isn't the same as volatility, though the latter is what is actually minimized. Here are some of the piece's key passages,

"But what if there were a way to beat the stock market's returns over the long haul with significantly less short-term instability?

More surprising, however, is that the Low-Volatility Index has returned 80% during the past 10 years, compared with the S&P 500's 42.9%, assuming reinvested dividends. Go back 20 years, a period that includes most of the go-go 1990s, and the index has beaten the S&P 500 by about 180 percentage points, according to S&P, which set up the Low Volatility Index in April.

The success of low-volatility investing flies in the face of what most investors consider the central axiom of investing: the greater the risk, the greater the reward.

The low-volatility strategy has some downsides. The biggest: It can underperform badly when the overall market is rising. That is because investors tend to pile into riskier stocks during big rallies. For example, the S&P Low-Volatility Index approach gained only 19.2% in 2009, compared with 26.5% for the S&P 500.

Sometimes the market can rally for long stretches, making the pain of missing out even worse. Low-volatility stocks gained 126% for the eight years leading up to the dot-com peak in March 2000, for example—less than half of the S&P 500's 307% rise.

The upshot: Investors who embrace this strategy should be focused on the long term.

"You need to have an honest conversation with yourself," says Joe Wolfe, director of quantitative research at Northern Trust in Chicago. "You have to be able to live with the results."

Yet even if market sentiment turns to riskier assets, investors aren't likely to lose money, says Pim van Vliet, a senior portfolio manager at Robeco—they will underperform only until the next bout of risk aversion. "If your neighbor earns a lot of money, you may feel poor," Mr. van Vliet says. "But if you look at what you can do with your money, you'll feel rich." "

Let's take the points in order.

It's usually most helpful to describe equity strategy performance in terms of a timeframe, its gross or net basis, and a compounded or arithmetic average annual over the period. Thus, it's not clear just what the average annual differences are between the S&P Low Volatility Index and the S&P500 Index. The claim of performance difference of "180 percentage points" over the past twenty years is even more difficult to assess, as it is a single net figure. I happen to know, though, from some recent work, and Penn's noted finance professor, Jeremy J. Siegel's remark on the exact same phenomenon, that the past 20 years of the S&P500 performance are the same as its long-run average, which is a bit over 11% per year, gross. No dividend reinvestment, which distorts results.

So to suggest that the past two decades are unusual is wrong. But it's hard to know precisely what the claim means, compressing so much information into literally a single net performance number.

All of those performance statistics omit what I have learned, from experience in the industry, is among the most important characteristics which institutional investors use to evaluate equity strategies- the duration and magnitude of so-called drawdowns. These are the periods during which a strategy continues to underperform relative to its benchmark, on a monthly basis.

Simply stating that a low volatility strategy outperforms the S&P by 180 percentage points over 20 years tells us nothing about how consistent that performance was. How badly it trailed the S&P500, cumulatively, at its worst point. This is important information for several reasons.

First, consistency has a value. And inconsistent approach which has a few runs of extreme outperformance isn't as valuable as a more consistent approach which may have a lower average annual return.

Second, inconsistency, or volatility of returns, especially posting negative absolute or relative (to the benchmark) returns, is precisely the sort of performance which leads investors to suspect a strategy no longer works, and abandon it. That's why the exclusive use of backtesting can mislead. Without any live data, including, if appropriate, redemptions, it's impossible to know whether real investors would have calmly absorbed losses and remained invested in a strategy.

The next point, that there is some proven relationship between all returns and risks, is simply false. My own proprietary equity strategy has outperformed the S&P500 by more than two-fold, on a gross basis, over the past twenty years, with considerably lower volatility. I'm not alone in managing to do this. Those equity managers who really find niches of superior performance deliver less volatility, while the mainstream subjective horde of stock pickers and index-shadowers typically do not.

The last general point of the passages concerns the lower returns the low volatility equity portfolio approach earns during periods of rising markets.

The fact is that, over the long term, the S&P500 rises about 2/3 of the time, on a monthly basis. And it earns more in a positive month, in absolute magnitude, than it typically loses in a down month.

Moreover, volatility has risen, and fallen, by my proprietary measure, frequently over the past decades. The article discusses volatility as if it's a contemporary, observable phenomenon. It isn't. Often the specific nature of market volatility- its duration and magnitude- isn't really clear until a good way through a bout of either high or low volatility. On a monthly basis, which is how most portfolio performances are measured, and often investment decisions made, fairly typical market turbulence may be indistinguishable from unusually high volatility for a while.

Thus, between potentially switching in and out of the low volatility approach, and getting timing wrong, and the cost of actively running such an approach, it may not be the panacea which the Journal article suggests.

Moreover, comparing such a strategy to a purely passive S&P500 Index return isn't strictly correct, either. The latter, when used as a primary equity investment vehicle such as the Vanguard S&P500 Index fund, is typically invested monthly for a dollar-averaging effect. That makes the raw S&P 500 return no longer equal what a typical investor is realizing. Thus the need for a more detailed performance comparison than one or two net returns over a long period with no assumptions explicitly stated.

However, as I've explained to inquiring colleagues recently, if you're dollar-averaging a passive S&P index fund already, you can do even a little better with this simple tactic. If the S&P has risen above its long term average rate for the past few prior months, invest less than your average monthly target. If it's been underperforming its long term average for the past few months, invest a little more than your target monthly amount. For investors with a long time horizon, this effectively adds more investments when the S&P is relatively lower, and less when it's higher, thus providing a little more return on the same passive index stream. What's actively managed is the amount of investment each month, not the equities in the fund.

I'm frankly surprised that the Journal ran this article without some sort of rigorous academic test of the implicit hypothesis that a low volatility strategy is superior to the S&P500 Index. And a test involving more than just backtesting.

Call it what you will, a low volatility approach is a cousin of the long-discussed low-beta approach. As the article mentions, then dismisses, if such a simple, long-known effect really exists, you can bet it would have been exploited into triviality long ago.

In summary, I found the Journal's piece on low volatility equity strategies, while interesting, to be far short of conclusive. And entirely lacking in the rigor appropriate to include a section providing detailed advice and options for actively implementing such an approach..

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