A Dynamic Equity Strategy For A Volatile Year Ahead

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Includes: ACWV, EEMV, EFAV, FV, GSLC, IMTM, MTUM, PDP, QLEIX, QMNIX, SPLV, USMV
by: George Kiraly Jr.

Summary

Low-volatility strategies deliver superior risk-adjusted returns and have outperformed the S&P 500 Index over multiple time periods.

Using momentum within a dynamic asset allocation approach can enhance returns and reduce risk. Momentum investing consistently reduces the risk of holding poorly performing securities.

Given the expected continuation of higher volatility, investors should consider adding liquid alternatives to portfolios, including long-short and/or market-neutral strategies.

A combination of low-volatility, momentum and liquid alts will likely add meaningful alpha as the year progresses.

Introduction

Global stock markets have had their worst start to a new year in decades. Many developed markets are down over -20% from their respective highs. The S&P 500 is down approximately -12% from its May 2015 peak and -8% in January alone. Approximately one-half of the S&P 500 Index's components are down -20% or more from their 52-week highs. We're most likely in for a challenging investment environment in the year ahead. A combination of low-volatility, momentum and liquid alternatives (liquid alts) will likely generate alpha in 2016.

Low-Volatility

Numerous studies have shown that low-volatility investing offers superior risk-adjusted returns compared to its high-volatility counterpart and market-cap weighted benchmark portfolio over a full market cycle. We have argued that low-volatility funds such as the iShares MSCI USA Minimum Volatility ETF (NYSEARCA:USMV), PowerShares S&P 500 Low Volatility ETF (NYSEARCA:SPLV), iShares MSCI EAFE Minimum Volatility ETF (NYSEARCA:EFAV), iShares MSCI All Country World Minimum Volatility ETF (NYSEARCA:ACWV), and the iShares MSCI Emerging Markets Minimum Volatility ETF (NYSEARCA:EEMV) should be used as a continuing strategic component or core holding of an investor's overall portfolio, rather than a tactical component.

Less volatile stocks help provide a smoother performance pattern and stronger downside-risk protection.

USMV vs. SPY

One-Year Chart

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Two-Year Chart

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Three-Year Chart

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Momentum

Momentum investing is a time-tested strategy for building portfolio efficiency and diversification, while generating excess returns. It identifies securities with good relative performance in rising, neutral and falling markets.

A momentum strategy consistently reduces the risk of holding poorly performing securities. It is particularly beneficial when combined with a value component, and thus would complement low-volatility strategies. Momentum and value each deliver positive excess market returns, but because they are negatively correlated, the combination lowers risk and improves portfolio efficiency.

You can expect higher risk-adjusted returns by adding a momentum component to your portfolio.

The iShares MSCI USA Momentum Factor ETF (NYSEARCA:MTUM) tracks the performance of an index that measures the performance of U.S. large-cap and mid-cap stocks exhibiting relatively higher momentum characteristics. It currently holds 123 stocks and has an annual expense ratio of 0.15%.

Consumer Discretionary (30%), Information Technology (26%), Consumer Staples (17%) and Health Care (12%) represent 85% of the fund. Its top three holdings include Facebook (NASDAQ:FB), Amazon (NASDAQ:AMZN), Home Depot (NYSE:HD) and Starbucks (NASDAQ:SBUX).

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MTUM happens to be at a new high relative to the total market, which may be a bullish sign for the momentum names.

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MTUM vs. SPY

One-Year Chart

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Two-Year Chart

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Three-Year Chart

Click to enlarge * MTUM began trading on April 16, 2013

Several other momentum-based ETFs may be worth a look. The First Trust Dorsey Wright Focus 5 ETF (NASDAQ:FV) targets the five sector and industry based ETFs which offer the greatest potential to outperform on a continuous basis. Another Dorsey Wright-based fund is the PowerShares DWA Momentum ETF (NYSEARCA:PDP). It follows the Dorsey Wright Technical Leaders Index, a benchmark that adheres to the Dorsey Wright relative strength methodology. Goldman Sachs has recently entered the ETF space with a successful fund. The ActiveBeta US LargeCap Equity ETF (NYSEARCA:GSLC), which is powered by a proprietary methodology based on the Goldman Sachs ActiveBeta index, was cited as one of the best new ETFs for 2015 by Morningstar. It has one of the lowest annual expense ratios (.09%) in this ETF space.

Momentum is found across all asset classes and is not constrained by geographical boundaries. The iShares MSCI International Developed Momentum Factor ETF (NYSEARCA:IMTM) takes its factor-driven approach to the EAFE countries. This new ETF, which came to market in early 2015, features an almost 32.92% weight to Japan with another combined 21% allocated to Germany and the United Kingdom. None of IMTM's 292 holdings command a weight of more than 2.60%. The ETF's top 10 holdings include Novo Nordisk (NYSE:NVO), SAP SE (NYSE:SAP) and Unilever (NYSE:UL)

Liquid Alts

Liquid alternatives put hedge-fund-like strategies into mutual funds and ETFs. They aim to diversifying away from stocks and bonds, and dampen volatility. Liquid Alts work well in a higher-volatility environment.

"Market neutral" is a popular hedge fund strategy that uses both long and short position, or borrowings, to make a profit. Long-short strategies are best suited to investors who expect low returns from stocks going forward.

The AQR Long-Short Equity Fund (MUTF:QLEIX) invests in individual equities and equity-related instruments of companies in global developed markets. It combines three independent sources of potential returns: security selection, passive market exposure and tactical market exposure.

QLEIX vs. SPY vs. AGG

One-Year Chart

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Two-Year Chart

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Three-Year Chart

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We also like the AQR Equity Market Neutral Fund (MUTF:QMNIX). Its annual expense ratio is capped at 1.35%, which is low in comparison to other similar funds. It goes long and short equities based on fundamental measures of value, momentum and quality.

The Fund strives to produce positive absolute returns by taking long and short positions in equity and equity-related instruments that, based on proprietary quantitative models, are deemed to be either undervalued (and likely to increase in price) or overvalued (and likely to decrease in price). QMNIX is not restricted by market-cap size or geography, but it invests primarily in developed markets.

QMINX was up +17.60% in 2015, and this year is far outperforming the S&P 500. The fund is ahead almost 3% vs. a decline of about -8% for the S&P 500.

Conclusion

Investors should expect a more volatile year ahead.

Low-volatility, momentum and liquid alternative investments can add meaningful alpha relative to the broader market. Utilizing a combination of all three strategies in your portfolio will likely allow you to lower your portfolio's risk while creating excess returns.

Additional disclosure: George Kiraly Jr., CFP, MBA is the president of LodeStar Advisory Group, LLC, an independent Registered Investment Adviser located in Short Hills, New Jersey. George Kiraly, LodeStar Advisory Group, and/or its clients may hold positions in the ETFs, mutual funds and/or any investment asset mentioned above. The opinions offered herein are not personalized recommendations to buy, sell or hold securities.

Disclosure: I am/we are long ACWV, EEMV, EFAV, SPLV, USMV, MTUM, QMNIX.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.