It is estimated that 180,000 Chinese immigrated to the United States in the latter half of the 19th century; many of them worked on the Transcontinental Railroad. Deeply routed in Chinese culture, the immigrants brought with them various medicinal remedies for common ailments. It was believed that the oil of Chinese water snakes was effective in treating inflammation and arthritis. Given the harsh working conditions, such a remedy was particularly applicable for the grueling physical labor required for the railroad.
At some point, the Chinese workers shared these medicinal powers with their American rail-worker brethren. While it is believed this original version of snake oil actually worked as promised, the popularity of cure-all tonics soon consumed the nation. The exploits of entrepreneur Clark Stanley became stuff of "cure-all" legend after a "demonstration" at the 1893 World's Fair. And so, as many ideas before, and after, an entrepreneurial fraudster exploited an otherwise effective and innocuous product for pure financial gain. After being raided by the feds, it was found that Stanley's tonics didn't include snake oil of any kind.
In the investment world, snake oil exists, but in the original truly effective form. In our research, we've come across dozens of investment factors that indeed appear to be promising, yet most of them hit the cutting room floor upon closer inspection. In a recent article, Research Affiliates wrote of a Smart Beta crash, noting in particular that Low Volatility strategies appear expensive. I couldn't agree more.
I'll take it a step further and argue that Low Volatility strategies are just re-packaged Value strategies. I'll explore in a series of posts: what the historical research reveals on low volatility as a factor, what is actually driving the outperformance of low volatility strategies, and why investors might want to reconsider those Low Volatility ETF's (USMV and SPLV) which have performed so well, and gathered so much in assets, over the last several years.
What does history tell us about Low Volatility investing?
To be clear, I'll define volatility as the 12-month standard deviation of a stock, or portfolio. Low volatility are those stocks whose stock prices vary the least over time, while high volatility is obviously the opposite, those stocks with price charts that look like an EKG machine. Below, I ran an analysis on a universe of Large Stocks based on volatility. Imagine, for example, there were 1,000 stocks in our Large Stocks universe. I organize them into 10 portfolios of 100 stocks each. I refer to these as decile portfolios. The portfolios are rebalanced on a rolling annual basis from 1964-2015. The annualized excess returns shown in the chart are the out(under)performance relative to the market--Large Stocks.
What you see is that, yes, stocks with lower volatility generally outperform the market. On the flip side, betting on highly-volatile stocks underperforms by a wide 4.3% margin. All things being equal, the inference is that you would want your portfolio to stray away form high volatility and tilt to low volatility.
In an ideal world, you would like to see a nice monotonic trend of steadily increasing excess return from lower right to upper left in the pattern above, similar to the arrow super-imposed below. What actually happens though is that the lower volatility deciles level off and don't do that much better than the 4th or 5th deciles.
Next, I look to the consistency of outperformance. In other words, what is Low Volatility's batting average versus the market? Do low volatility stocks consistently outperform? The chart below shows the percentage of time that each decile beats the overall market in rolling 5-year periods. Anytime the green bar rises above the dotted gray line (50%), it means that decile's batting average is greater than 50% and the decile beats the market more than it loses, i.e. better odds than a coin flip. A reading of 100% would mean that the decile always beats the market. Conversely, a reading of 0% means that the decile always loses to the market.
Oddly, the Low Vol decile is not the one that outperforms most consistently. The consistency crown falls to deciles 4 and 5, despite the fact that they only deliver 1.1% and 0.8% annualized outperformance. So, on the measure of consistency, additional questions are raised. This suggests that performance is highly cyclical--meaning periods of strong performance can be clustered in certain periods or persist for just a few years, only to be followed by underperformance for several years. The chart below shows 5-year excess returns for the Low Vol decile from 1964-2015. You can see that Low Vol worked fantastically for the 70's and 80's.
These periods make up the bulk of outperformance shown in the overall statistics. Since then, however, Low Vol has struggled mightily in the run up to the tech bubble and market peak prior to the credit crisis. Since 2011, the factor has strung together fairly consistent outperformance. On a rolling 5 year basis, the last 5 years have been among the best periods for Low Vol historically, eclipsed only by the post tech bubble early 00's recovery and post recession in the early 1980's.
It has been my experience that when you do not see clear patterns based on excess return, the driver of performance can be coming from some other exogenous factor.
Low Volatility investing is not a panacea. Like the real snake oil, low volatility has morphed from an historically so-so factor to one that has peaked the interest of many individual and institutional investors alike. The factor does work as intended, but it is not a cure all for client or institutional portfolios who are concerned about minimizing risk. All else equal, you want your portfolio to be less volatile, but expect low volatility strategies to come into and out of favor over time.
In my next two posts, I'll walk through the evidence that Low Vol investing is a re-packaged Value strategy, and why investors might want to reconsider investments in Low Volatility ETFs like USMV and SPLV.