5 Simple Ways To Beat The Market: Part 3 Of 5

| About: PowerShares S&P (SPLV)

Summary

Investors should understand simple and easy-to-implement strategies that have been shown to outperform the market over long time intervals.

The third of five strategies I will describe in a series of articles is the "low volatility factor" that has seen these stocks outperform over time.

The Low Volatility Anomaly runs counter to how many investors see the world, but is supported by academic research and could be a successful holding for long-term investors.

Today's article is the third part in a five part series with two additional articles to follow over the next five business days. Through the course of this series, I will be showing readers five buy-and-hold approaches that have historically "beat the market," providing absolute and risk-adjusted returns in excess of the most commonly used domestic equity benchmark - the S&P 500. All of these articles have already been penned, and I will be arranging with Seeking Alpha editors to publish the remaining articles over the next two mornings (east coast U.S. time).

In my two previous articles in this series, I have shown that the proportion of households with direct stock ownership has been falling even as indices have rallied to new all-time nominal highs. Despite falling barriers to entry and reduced trading costs, only one in seven U.S. households directly owns stocks in non-retirement accounts. My second article in this series highlighted through Vanguard data that investors owned less stocks after the massive drawdown in 2008 and likely missed part of the early stock market recovery.

Many novice investors should simply use low cost exchange traded funds like the SPDR S&P 500 ETF Trust (NYSEARCA:SPY), which replicates the return of the S&P 500 that we have historically paid money managers high fees to fail to "beat" on average over time. Understanding that on this portal, readers are "Seeking Alpha", or the ability to earn risk-adjusted returns in excess of the market, my articles implicitly assume that readers have decided that market returns are not sufficient for them, and have chosen to take active bets in an effort to outperform. This article describes the third of five buy-and-hold approaches that have outperformed the market over the trailing twenty years. These strategies are factor tilts from the broader market, and I will describe, supported by academic research, why I believe they have generated long-run alpha.

Low Volatility

Since the groundwork behind the Modern Portfolio Theory was laid fifty years ago, it has been axiomatic that riskier portfolios should expect to be compensated with higher returns. More recent academic research has shown that this assumption holds less well at the extremes - the least risky stocks tend to outperform the most risky stocks on both a risk-adjusted and an absolute basis. In a 2012 paper by Nardin L. Baker of Guggenheim Investments and Robert A. Haugen of Haugen Custom Financial Systems entitled: "Low Risk Stocks Outperform Within All Observable Markets of the World", the pair demonstrated that in their thirty-three country sample the highest risk decile of stocks, rebalanced monthly, underperformed the lowest risk decile of stocks in each locale.

Source: Nardin & Baker (2012)

Recently, Andrea Frazzini, David Kabiller, and Lasse Pedersen, each affiliated with hedge fund AQR Capital Management, published "Buffett's Alpha", which deconstructed the return profile of Berkshire Hathaway (BRK.A, BRK.B). In "Buffett's Alpha", the authors determined that the public stocks owned by Buffett in 13F filings had only a market beta of 0.77 from 1980-2011. Over that thirty-one year period, Buffett outperformed the market while owning in the public portion of his portfolio securities which on average had only three-quarters of the market beta. At the 1999 Berkshire Hathaway Annual Meeting, Buffett, during the rising crescendo of the tech bubble stated: "We're more comfortable in that kind of (traditional) business. It means we miss a lot of very big winners. But we wouldn't know how to pick them out anyway. It also means we have very few big losers - and that's quite helpful over time. We're perfectly willing to trade away a big payoff for a certain payoff." From the chart above by Haugen and Baker, the end of the 1990s was the period when the most volatile stocks were actually outperforming the least volatile stocks as earnings multiples for start-ups in the tech space reached stratospheric heights. Buffett, as his 1999 quote illustrates, chose to pass and his relative performance in the short-run faltered, but over the long run he avoided the tech bubble-fueled market meltdown. Missing these major market corrections has been a predominant source of Buffett's sustainable alpha. This is consistent with the return profile for the low volatility strategy as seen in the cumulative graph of the S&P 500 Low Volatility Index versus the S&P 500 below:

Source: S&P, Bloomberg

Source: S&P, Bloomberg

Buffett has historically been called a "value investor", but as we saw in my second article in this series, while value investing produces higher long-run returns, it also has higher variability of returns. The AQR researchers saw low volatility investing and leverage as key to Buffett's success, and I have chosen to discuss them in this series as separate, but related strategies. From an analytic standpoint, the correlation coefficient of the S&P Pure Value Index and the S&P Low Volatility Index has been roughly equivalent to the correlation between the S&P 600 Smallcap Index (covered in my first article in this series) and low volatility stocks, and few would argue that the latter pair has exposure to similar risk factors. Certainly, Buffett's ability to miss the bursting of the tech bubble was highly correlated with the return series for low volatility stocks above.

If we can take a subset of the broader market, low volatility stocks, and demonstrate that they have outperformed, then another segment of the market must be underperforming. Over the twenty-year time period we are examining, high beta stocks have fit that mold, and that underperformance is captured in the graph of the cumulative returns of low volatility stocks and high beta stocks below:

Source: Standard and Poor's; Bloomberg

Two of the three authors of "Buffett's Alpha", Andrea Frazzini and Lasse Heje Pederson also collaborated on "Betting Against Beta" where the researchers demonstrate that since leverage constrained investors bid up high-beta assets, that high beta is necessarily associated with lower alpha. The articles demonstrates the underperformance of high beta across more than 20 global equity markets and several fixed income markets. This analysis makes intuitive sense. Long-only active managers who are benchmarked against an index naturally seek higher beta assets as a means to outperformance, but the cumulative effect of this preference for riskier assets lowers their expected forward returns as compared to disfavored lower beta stocks.

The S&P 500 Low Volatility Index is replicated through the exchange traded fund, Powershares S&P 500 Low Volatility Portfolio (NYSEARCA:SPLV), which carries a 0.25% expense ratio. The raw beta of this fund over the trailing 1-year is just 0.75, consistent with Buffett's beta in the aforementioned study. I have seen some market commentary that suggests that low volatility stocks are overpriced as the market has figured out the Low Volatility Anomaly. That does not appear to be the case when the price multiples of constituents of the Low Volatility Index, the S&P 500, and the High Beta Index are compared:

Source: S&P, Bloomberg

My favorite part of this low volatility strategy for buy-and-hold investors with a long-term horizon is that the strategy has outperformed when the stock market has been falling, besting the broader market in 2000-2002 and 2008. The low volatility strategy underperformed the most in 1998 and 1999 as tech multiples ballooned and Buffett was forced to defend his underperformance, but the strategy far outpaced the broader market in the 2000-2002 correction. While the Low Volatility Index will be more sensitive to higher interest rates than other segments of the equity market, I continue to expect that low volatility stocks will continue to offer attractive risk-adjusted returns over the business cycle.

Disclosure: The author is long SPLV.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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