7 Ways To Beat The Market: Low Volatility Update

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About: Invesco S&P 500 Low Volatility ETF (SPLV), Includes: SPHB, SPY
by: Ploutos
Summary

In an ongoing series of articles, I have highlighted five buy-and-hold strategies that have historically outperformed the S&P 500.  In this series update, I have added two additional strategies.

Even with stocks near record highs, a large number of Americans have failed to participate in the equity market despite falling barriers to entry.

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

The third of seven strategies I will cover in this series of articles is the "low volatility anomaly" which has seen lower volatility stocks produce higher risk-adjusted returns over time.

In my "5 Ways to Beat the Market" series, some investors have the most difficulty with seeing the market-beating potential of the Low Volatility Anomaly. Size and value, the first two methods of outperforming the broad market gauge that I have discussed already in this series update are more intuitive to most investors. In contrast, low volatility runs counter to our intuition that investors should be paid higher returns for taking more risk of loss. While that is correct in a model, higher risk has not translated into higher returns in practice across asset classes, geographies, and extended time horizons. Lower volatility investments have delivered higher risk-adjusted returns than a model would predict. Whether this is a function of cognitive biases of investors, risk-seeking behavior, the conflicts of delegated investment management versus a benchmark, or aversion to leverage, low volatility strategies have often delivered higher risk-adjusted and absolute returns.

To depict the relative performance of low volatility strategies, the graph below shows the S&P 500 (SPY) graphed against its 100 lowest volatility (SPLV) and highest beta constituents (SPHB) of the broad market benchmark, rebalanced quarterly. The Low Volatility Index has produced higher returns over the past three decades with lower variability and smaller drawdowns.

Low volatility, high beta, and S&P 500 over three decades Source: Bloomberg

In the first half of 2019, the S&P 500 had its best start to the year since 1997. In a risk-on environment, you might expect low volatility stocks to underperform. They actually bested the broad market index (19.5% total return in 1H19 vs. 18.5%). Small-caps and value stocks - the first two strategies discussed in this series - actually lagged despite their tendency to do well in up markets. The first half of 2019 was a unique environment as a large interest rate rally and rotation into defensive stocks buoyed low volatility stocks even in a broad-based rally for the stock market.

The Low Volatility Anomaly has been one of the topics I have most frequently authored on Seeking Alpha. Beginning in July 2015, I described a theoretical underpinning for why lower volatility stocks have historically generated risk-adjusted outperformance, behavioral explanations for the market advantage of low volatility assets, suggested that misaligned managerial incentives could encourage the anomaly, and offered empirical evidence supporting this notion across markets, geographies, capitalization levels, and long-time intervals.

Since the groundwork behind the Modern Portfolio Theory was laid over 50 years ago, it has been axiomatic that riskier portfolios should expect to be compensated with higher returns. In A Trade That Never Wins Lost Again in 2018, I showed that in a dataset covering the next 50 years following the publication of that research, risk and returns have actually been inversely correlated. This longer-run dataset may counter any notion that the success of the Low Volatility Index since 1989 is simply a function of falling interest rates.

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 as depicted in the table of full-year annual returns below of the investable low volatility and benchmark cap-weighted indices.

S&P 500 Low Volatility vs. S&P 500 The low volatility strategy underperformed the most in 1998 and 1999 as tech multiples ballooned, but the strategy far outpaced the broader market in the 2000-2002 correction. A relative performance that is demonstrable in the first chart in this article.

In each of the down years for the broad market this century - 2000-2002, 2008, and 2018, the low volatility strategy has outperformed. In a strong market like 2019, low volatility has also kept pace as forward-looking investors gravitate towards more defensive equity strategies. Unlike size and value that are early recovery outperformers, low volatility outperforms in economic contractions, but has managed to keep pace in recoveries to generate outperformance through a business cycle.

For more on Low Volatility strategies, see my following articles.

Practical implementations of Low Volatility strategies:

Academic underpinning of strategies:

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 SPLV,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.