Combining The Volatility And Value Anomalies

by: Ploutos

Risk and return. We can complicate investing in a myriad of ways, and investors can utilize a multitude of strategies, but ultimately we are trying to maximize investment returns for our own unique risk threshold over our investment horizon. When I step back and think about how I invest holistically, it is always about ways to generate higher risk-adjusted returns over time.

Recently, I came across a paper from Priscilla Luk, Xiaowei Kang, and Frank Luo entitled Introducing GIVI: The S&P Global Intrinsic Value Index that demonstrates a strategy that has produced higher risk-adjusted returns over the last decade in a host of global equity markets. Like my previous articles regarding the Dividend Aristocrats and momentum strategies, the paper illustrates a rules-based strategy to achieve this objective, which Standard and Poor's is now replicating through a series of global equity indices. The strategy implemented in this paper and the indices is designed to capture the low volatility anomaly, and uses an alternative stock weighting scheme that attempts to proportion the index components by intrinsic value rather than market capitalization.

The S&P Global Intrinsic Value Index begins with more than 11,000 stocks from 46 emerging and developed countries in its S&P Global Broad Market Index as its population. The S&P GIVI then excludes the 30% of market capitalization with the highest beta over the trailing five years in each country. This index then weights the remaining stocks by their intrinsic value derived from a mathematical model based on current book value and the discounted value of future projected earnings. The index caps a component's weight at its market cap weight in the S&P Global BMI.

The paper demonstrates that a strategy that selected low volatility stocks and weighted them by the intrinsic value measure outperformed the capitalization-weighted broader market from 2000-2011.

Skeptics can rightfully point out that this time frame marked a very weak period for global equity returns, encapsulating the tech bubble and the 2008 crash. While the companies chosen through the intrinsic value index methodology produced higher average returns with lower variability of returns over this period, low volatility stocks and those trading at lower multiples should have been expected to outperform given the market turmoil. While it is difficult for me to dismiss this backcasting, I believe that several attributes of the Global Intrinsic Value Index are meritorious and should influence how equity portfolios are shaped.

This strategy marries interesting alternative weighting methodologies - volatility and value - which could produce outsized returns versus the market. Excluding the highest volatility stocks produced a lower annualized volatility than the broader market in each of the twelve years, and as seen above, volatility was lower in each of the sub-markets on average over this period as well. This strategy will reduce risk, but will it consistently produce excess return? A strategy that equal-weighted the constituents of the S&P 500 index (replicated through RSP) produced 209bp of incremental return from 1990-2011 over the capitalization-weighted S&P 500 (SPY, IVV), demonstrating the drawbacks of traditional capitalization-weighted approaches to equity exposure. Choosing an intrinsic valued weighting methodology to the traditional capitalization-weighting seeks to allocate incremental dollars to stocks which are underpriced in the market based on fundamentals, which hopes to be a source of alpha. Another source of alpha could be simply from missing large negative returns from companies that go out of business. A recent 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" demonstrates that the highest volatility stocks have systematically underperformed the lowest volatility stocks over rolling three-year periods for the past two decades. Part of the S&P GIVI's past success and potential future outperformance is the exclusion of these high volatility underperformers.

Unfortunately, there is not yet an exchange traded fund that replicates these newly launched S&P intrinsic value indices yet. S&P Indices has licensed the S&P GIVI and its complete family of 2000 indices covering emerging market, developed market, and country-specific sub-indices across forty-six countries and seven currencies to Goldman Sachs (NYSE:GS). Expect funds that use these indices as their benchmark to potentially be launched in the near future. Until then, below are the top ten components of the Global Intrinsic Value Index to give investors a flavor of the companies included. For more information and historical performance, see S&P's fact sheet on the indices.

I hope Seeking Alpha readers take away from this article an appreciation for low volatility strategies, especially those who seek to bridge the gap between anemic fixed income returns and equity market volatility, an illustration of a broad value investing-based approach, and an appreciation for alternative weighting methodologies that can help produce our goal of higher risk-adjusted returns.

Top Ten Constituents of the S&P Global Intrinsic Value Index

Exxon Mobil (NYSE:XOM), Apple (NASDAQ:AAPL), Microsoft (NASDAQ:MSFT), Chevron (NYSE:CVX), British Petroleum (NYSE:BP), HSBC Holdings (HBC), General Electric (NYSE:GE), Vodafone (NASDAQ:VOD), International Business Machines (NYSE:IBM), and Pfizer (NYSE:PFE).

Disclosure: I am long SPY, RSP.