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In my quest to present readers strategies that generate repeatable and sustainable outperformance, two themes have often permeated my articles - the low volatility anomaly and momentum. The former theory, the low volatility anomaly, was covered in my recent article entitled Making Buffett's Alpha Your Own, which showed that the use of leverage on low volatility stocks historically replicated the Oracle of Omaha's stellar track record. The latter theory, momentum, suggests that investors who ride the momentum of a hot trade can generate market outperformance, typically by a switching strategy using imperfectly correlated asset types.

For the last 20 years, Standard & Poor's has produced indices which bifurcate the S&P 500 constituents into low volatility and high beta components. Both indices are beta-weighted and rebalanced quarterly. The S&P 500 Low Volatility Index, replicated through Powershares' SPLV, is composed of the 100 S&P 500 constituents that have experienced the lowest realized volatility over the trailing one year. The graph below demonstrates that over the past 22 years, this portfolio of low volatility stocks has generated higher average returns and lower variability of returns than the broader market index.

Source: Standard and Poor's

The S&P 500 High Beta Index, replicated through Powershares' SPHB, is conversely constructed from the 100 S&P 500 constituents with the highest realized volatility, and offers investors bullish on domestic equities the opportunity to make strategic bets on the stocks in the broad market gauge most sensitive to market movements. Despite having roughly twice the variability of returns of the S&P 500, the high beta index has underperformed the broader market over the trailing twenty-two years. The high beta index does have its moments in the sun when markets are broadly rallying. Note the tremendous outperformance in the tech-driven late 1990s rally. Recent returns have also been impressive, including 17% returns in both 4Q11 and 1Q12 as the market recovered from European contagion fears and the debt ceiling drama.

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Source: Standard & Poor's, Bloomberg

A look at the current industry mix and top ten components of each index demonstrates the relative differences in business risk between the two indices. The low volatility index is populated by electric utilities (26%), food companies (13%) and pharmaceuticals (10%), companies that generate consistent performance in part due to their essential nature and/or regulated operating environment. The top ten holdings include five utilities - The Southern Company (SO), Dominion Resources (D), Consolidated Edison (ED), Duke Energy (DUK), and NextEra Energy (NEE) - two food and beverage giants - PepsiCo (PEP) and General Mills (GIS) - and three producers of non-cyclical consumer goods - Clorox (CLX), Johnson & Johnson (JNJ) and Kimberly-Clark (KMB).

The high beta index is dominated by financials with banks (12%), insurance (9%), and financial service companies (7%) heavily represented. Oil and gas producers (16%) and semiconductor companies (7%) round out the top five sectors. The largest holdings in the high beta index are from more diverse businesses than the low volatility constituents, but their volatility has been well documented over the trailing twelve months. The top ten holdings are populated by topical financials - Genworth Financial (GNW), Morgan Stanley (MS), and Citigroup (C) - flagging semiconductor maker Advanced Micro Devices (AMD), domestic steel names U.S. Steel (X) and Allegheny Technologies (ATI), solar module manufacturer First Solar (FSLR), homebuilder and top 2012 performer PulteGroup (PHM), building materials company Masco (MAS), and communications equipment company JDS Uniphase (JDSU).

While low volatility stocks have produced higher risk-adjusted returns over long time periods, high beta stocks tend to outperform sharply when markets are rising as witnessed by the 57% annual post-recession returns in 1991 and 2009. A momentum trade that purchases low volatility or high beta stocks based on which factor outperformed in the trailing quarter and holds that class of securities forward for the next one quarter has produced meaningful absolute outperformance historically. From January 1991 through September 2012, this momentum strategy has outperformed both the low volatility stocks, high beta stocks, and the broader market, outperforming the S&P 500 by roughly 4.8% per annum.

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This trade has more than doubled the cumulative return of an investment in the S&P 500 over the past twenty-two years. The secret behind the momentum trade's success is its ability to ride hot markets post-recession (1991, 2003 and to a lesser extent 2009) and avoid the major corrections. The strategy was invested in the Low Volatility Index for the entirety of 2008.

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Skeptics will point to the higher risk in the momentum trade. How much incremental risk does this trade entail? The table below details the relative performance of this momentum strategy against the return profile of Berkshire Hathaway (BRK.A) (BRK.B). From 1991-2012, the annualized standard deviation of quarterly returns of the momentum strategy and Berkshire Hathaway have been roughly the same. The excess return generated through executing the four trades per year needed to implement the high beta/low vol quarterly switching strategy has historically come with increasing your portfolio risk profile from the market risk profile to the risk profile of Berkshire Hathaway.

As I promised at the end of my previous article on a trade to replicate Berkshire's tendency to leverage low volatility stocks, I would provide Seeking Alpha readers another method for producing replicable returns without the use of leverage. A switching strategy between alpha-generative low volatility stocks and high beta stocks to glean the outperformance of riskier equities when markets are rising has historically produced significant outperformance relative to the broader market with a risk profile roughly equal to that of Berkshire Hathaway. Even if Seeking Alpha readers are disinclined to try the momentum strategy between SPLV and SPHB for themselves, understanding the historical outperformance of low volatility stocks and the benefits of tracking momentum should aid the long-run performance of any equity portfolio.

Source: Doubling The Return Of The S&P 500 Over 20 Years