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Low Volatility Didn’t Fail, It Adapted

Oct. 29, 2020
 

LOW VOLATILITY EQUITY FUNDS HAVE UNDERPERFORMED.

At least in the traditional sense, per popular low volatility indices and funds, as noted by the Wall Street Journal*. Low volatility funds have historically outperformed in crisis periods, yet captured the full downside of February and March 2020, while underperforming the ensuing rebound (Exhibit 1). History did not repeat itself, as low volatility funds actually enhanced the volatility of downside returns over the last 3 years.

Exhibit 1: Low Volatility Fund Performance

LOW DOWNSIDE VOLATILITY EQUITY FUNDS HAVE OUTPERFORMED.

However, a notable group of non-traditional low volatility funds did outperform, with a focus of low downside volatility over low total volatility. It appears the low volatility factor didn’t fail, it adapted, as traditional low volatility companies and sectors faced economic disruptions that no backtest could have captured. Adaptability is therefore a forward-looking concept that requires investors to move outside of well-researched comfort zones.

EQUITY FACTORS OUT OF FAVOR OR MISUNDERSTOOD?

Similar to low volatility, seemingly out of favor equity factors such as yield, value, and defensive have performed quite well (Exhibit 2) when viewed outside the prism of dogmatic methodology. Contrarian investors seeking the mean reversion of antiquated factor methodologies may find themselves waiting for quite some time. The best factors make intuitive sense and rarely (if ever) go out of favor, even if prevailing market assumptions cannot fully explain their effects. Though don’t expect traditional factor methodologies to go anywhere soon, as the financial industry finds comfort in long standing research, backtests, and style categorization.

Exhibit 2: "Out of Favor" Global Factor Performance

ADAPTABILITY OVER TREND CHASING.

Investors shouldn’t simply load up on funds with low downside volatility due to recent outperformance. That’s the same backward-looking trap that ensnared tactical investors of low volatility funds. Rather, the outperformance and diversification potential of the few funds capable of successful adaptation (Exhibit 3) has likely never been higher. As two “once-in-a-lifetime” market events in the last decade have shown, rigid approaches to traditional styles (e.g., value, growth, and low volatility) can have unintended consequences.

Exhibit 3: Equity Fund 3-Year Rolling Outperformance

AT THE END OF THE DAY, IT’S ALL ABOUT COMPOUNDING CAPITAL.

Simply put, this means reducing market downside while capturing its upside. This is of course easier said than done. As shown in Exhibit 3, only 1.3% of US large cap mutual funds and ETFs have outperformed the S&P 500 index on a consistent and long-term basis. Furthermore, Morningstar’s most recent Active/Passive Barometer semiannual report found that 71.1% of active and smart beta equity funds underperformed over the last 10 years as of 6/30/2020, 41.7% of which closed altogether. As low volatility funds have recently reminded us, history rarely repeats itself and you can’t backtest what hasn’t happened yet. Investors should consider the few managers with a long-term track record of forward-looking adaptability.

*Some Investors Tried to Win by Losing Less. They Lost Anyway. Wall Street Journal, September 18, 2020.

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