Earlier this month, I published an article that described a strategy that would have more than doubled the cumulative return of the S&P 500 (NYSEARCA:SPY) since 1990 with a risk profile resembling Berkshire Hathaway (BRK.A, BRK.B). This new article adds a slight wrinkle that further improves the performance of the strategy and lessens the volatility.
The original strategy combined two of the major themes predominating my investment philosophy and articles - the low volatility anomaly and momentum. Over the last twenty years, the S&P 500 Low Volatility Index (NYSEARCA:SPLV), which holds the one hundred constituents with the lowest trailing volatility, has outperformed its broader market benchmark on both an absolute and relative basis. My strategy combined the Low Volatility Index with its counterpart, the S&P 500 High Beta Index (NYSEARCA:SPHB) to form a momentum portfolio. A quarterly switching strategy that owns the low volatility or high beta index based on which had outperformed in the trailing quarter forward for the next one quarter produced the meaningful market outperformance seen below.
Several readers suggested to me that adding a return hurdle to the strategy could improve performance. Because the Low Volatility Index will outperform on a risk-adjusted basis over long time periods, setting a higher hurdle before switching to the High Beta Index will keep us invested in the more efficient Low Volatility Index, but not miss the strong rising markets that see the high beta index strongly outperform. An incremental return hurdle of 1% or 2% in the quarterly switching strategy further improved performance. In this analysis, the hurdle rate refers to an increment by which the high beta index had to beat the low volatility index for us to switch between the two asset classes.
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* Annualized mean and standard deviation of quarterly returns
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The simple lesson here is that in this strategy you prefer to own the Low Volatility Index even if the return profiles are relatively close together in the trailing quarter. A strategy that owns the S&P 500 Low Volatility Index, if it has outperformed or underperformed by less than 2%, or the S&P 500 High Beta Index based on trailing quarterly performance would have returned over 2.5x the S&P 500 return from 1991-2012. Thank you to my readers for their informative comments on my previous article, and look for an article that incorporates a fixed income component into this strategy in the coming days.