Low Volatility Didn’t Fail, It Adapted
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.
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.
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.
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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Benchmark and Fund Category Information.
Investors often use these well-known and widely recognized indices as one way to gauge the investment performance of an investment manager’s strategy compared to investment sectors that correspond to the strategy. You cannot invest directly in indices, which do not take into account trading commissions and costs.
MSCI benchmark returns have been obtained from MSCI, a non-affiliated third-party source. Neither MSCI nor any other party involved in or related to compiling, computing or creating the MSCI data makes any express or implied warranties or representations with respect to such data (or the results to be obtained by the use thereof), and all such parties hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability or fitness for a particular purpose with respect to any of such data. Without limiting the foregoing, in no event shall MSCI, any of its affiliates or any third party involved in or related to compiling, computing, or creating the data have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) even if notified of the possibility of such damages. The MSCI All Country World Index (ACWI) is a global equity index that tracks stocks from 23 developed and 24 emerging markets countries. The Index is net of foreign withholding taxes on dividends and is unmanaged. It is not possible to invest directly in an index.
MSCI ACWI factor-based indices are derived from the constituents of the ACWI using quantitative methodologies to target a sub-population of stocks; ACWI Value: low price to earnings and price to book ratios, ACWI Defensive: defensive GICS sectors consumer staples, energy, healthcare, and utilities.
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Performance Statistic and Fund Characteristics.
Standard Deviation (Total Std Dev): Absolute volatility measured as the dispersion of monthly returns around an average. Downside Standard Deviation (Down Std Dev): Absolute volatility measured as the dispersion of negative monthly returns around an average. Upside Standard Deviation (Up Std Dev): Absolute volatility measured as the dispersion of positive monthly returns around an average. Downside Capture Ratio (Down Capt Ratio): Performance in periods where the benchmark was down. Upside Capture Ratio (Up Capt Ratio): Performance in periods where the benchmark was up. Maximum Drawdown (Max Drawdown): Largest downside over a designated period, measured from return peak to trough.
EV/FCF Ratio: Market capitalization plus debt, minority interest and preferred shares, minus total cash and cash equivalents (Enterprise Value) to cash generated after accounting for cash outflows to support operations and maintain capital assets (Free Cash Flow). P/B Ratio: Price to company book value per share. Total Assets: Total of all short- and long-term assets as reported on the balance sheet. Economic Moat: Morningstar score of how likely companies are to keep competitors at bay for an extended period via the strength and sustainability of their competitive advantage.
Morningstar Active/Passive Barometer: Semiannual report that measures the performance of U.S. active managers against their passive peers within their respective Morningstar Categories. The Active/Passive Barometer report is unique in the way it measures active managers’ success relative to the actual, net-of-fee performance of passive funds, rather than an index, which isn’t investable.