A Strategy That Sells Itself

| About: PowerShares S&P (XSLV)

Summary

Small-cap, low-volatility stocks have historically trounced the S&P 500, producing annualized returns of 17-18% in a dataset stretching back to the 1960s.

These small-cap, low-volatility portfolios have produced much better risk-adjusted returns than the broader market.

These portfolios' minimum 10-yr annualized returns of around 7% provide a palatable downside scenario.

My salesmanship efforts need some work. In my last article, Small Caps and Low Volatility: A Long-Run Study, I thought that I had made a compelling case for a very successful long-run investing strategy backed by academic research. While the research that backed the article encouraged me to increase my allocation to this strategy, it remains at this point one of the least read articles I have authored. As Henry Ford once said: "Failure is only the opportunity to begin again, this time more intelligently."

In this article, I am going to endeavor to add a little more detail around why I believe this strategy is so compelling. In my last article, I included a simple table that showed the returns of 25 portfolios of NYSE-listed stocks sorted by capitalization size and realized volatility constructed by famed professor Kenneth French. The tremendous returns of low-volatility, small-caps in the upper left-hand corner of the table were meant to demonstrate the tremendous outperformance of exposure to these factors. The annualized returns in green exceeded the annualized return of the S&P 500 (NYSEARCA:SPY) of 9.91% over the sample horizon.

The best performing portfolio, the second-lowest volatility quintile in the smallest capitalization cohort, produced an annualized return of 17.96% per year, besting the S&P 500 return by over 8% per year. In a study period lasting more than 50 years, this led to extraordinary cumulative outperformance that may have been shrouded in this simple layout. The growth of $1 invested in the S&P 500 since July 1963 would be worth $154 today, but the growth of the highest performing portfolio would be worth $6,695, or more than 43x. Conversely, the cumulative return of the worst performing portfolio - small caps with the highest volatility - would be worth just 22 cents.

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The difference in the cumulative returns of these portfolios is staggering. How different has the realized volatility of returns been over time? The next chart shows the annualized standard deviation of monthly returns of the 25 portfolios. The portfolios in green had a lower risk measure than the S&P 500 (14.77%). The six lower risk portfolios included the lowest volatility small cap stocks, a portfolio that had generated 16.91% annualized returns that led to a cumulative portfolio value of $4,148. Investors in this portfolio would have made 27x more money than holders of the S&P 500, while experiencing lower variability of returns over time.

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A common convention in comparing historic returns and volatility is the Sharpe ratio. In the next table, I have subtracted the realized return of the 25 portfolios by the average yield on the 10-yr Treasury over this horizon (6.39%), and then divided that difference by the realized volatility of the portfolio to produce a quotient aimed at describing how well the portfolio compensated investors for the risk borne. All of the lowest volatility and low volatility portfolios produced better Sharpe ratios than the 0.24 of the S&P 500. The best Sharpe ratio was from the lowest volatility, smallest capitalization portfolio. None of the highest volatility portfolios compensate investors for the riskiness of those stocks.

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The Sharpe ratio can be a good measure of risk-adjusted returns, but some long-term investors may care less about volatility and more about the minimum realized return over their investment horizon. In the next table, I have included the minimum annualized return over a given 10-yr period. For the smallest capitalization, lowest volatility portfolios' annual returns were floored at around 7%. This compares to the -3.43% annualized return for the S&P 500 that included the 10-yr period that ended at the market trough in early 2009.

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Minimum annualized returns is an interesting downside case, but did owning lower volatility portfolios lead to lower upside in long bull markets? The table below shows the annualized 10-yr returns of these portfolios. All of the low volatility portfolios exceeded the best 10-yr period for the S&P 500 (+19.45%), which ended in August 2000 at the height of the tech bubble.

I may not be a very good salesman, but this data alone is very compelling. Small-cap, low-volatility stocks have generated tremendous outperformance with above-market, risk-adjusted returns and acceptable minimum realized returns even over their worst decade.

I attempt to capture the outperformance of low-volatility, small-cap stocks through the PowerShares S&P SmallCap Low Volatility Portfolio ETF (NYSEARCA:XSLV), which owns the 120 stocks with the lowest trailing one-year volatility in the S&P 600 SmallCap Index. The underlying index for this exchange-traded fund has generated nearly 14% annual returns since mid-1995, besting the S&P 500 by 4.7% per year. I am on the lookout for other compelling low-volatility, small-cap funds, so please share your own favorites in the comments section.

Disclaimer: My articles may contain statements and projections that are forward-looking in nature, and therefore inherently subject to numerous risks, uncertainties and assumptions. While my articles focus on generating long-term risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance and investment horizon.

Disclosure: I am/we are long XSLV, SPY.

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