While Punxsutawney Phil may be concerned each February with his shadow and what it implies about winter's duration, Bill Murray's character “Phil” in the movie “Groundhog Day” was focused on breaking free of the time loop in which he found himself, destined to repeat his mistakes until he arrived at a more enlightened way to live. So it goes in the world of investing where we see investors caught in a behavioral time loop, destined to repeat mistakes that inevitably end in red ink. The current strategy enticing investors to chase past performance is low-volatility investing.
As of Aug. 4, the trailing 12-month performance for the S&P 500 Low Volatility Index was a whopping 14.1%, while the S&P 500 gained a modest 5.5%. Of course, outperformance isn't necessarily a sign that something is amiss, and there's solid research that shows a low-volatility anomaly does exist (see “Minimum-Variance Portfolios in the U.S. Equity Market” in the Fall 2006 issue of the Journal of Portfolio Management). Therefore, we might expect equal or better performance with less risk over time from low-volatility stocks. As an asset manager offering low-volatility-based strategies, we at 361 Capital certainly believe that. But there's a difference between mindlessly plowing money into naïve approaches to low-volatility investing that by most measures look overvalued, and taking a more thoughtful, fundamentally driven and valuation-conscious approach.
We know that the payoffs to various factors, e.g., value, size and quality, change over time (see “Factor Investing: A Post-Modern Portfolio Theory”). Take value for instance. Whether or not you believe the payoff to value is a function of risk or due to behavioral biases, the evidence is clear that there is a premium that can be harvested. However, as all value managers understand too well, value can go out of favor for extremely long and painful periods of time.
That doesn't mean value doesn't work; it's simply that what investors are attracted to changes with the market environment. With that knowledge, investors have to choose between two paths.
Investing in smart beta products that provide pure factor exposure, knowing that no matter the factor, it will go through periods of outperformance, and in doing so, will rob the future of those same returns, as factor performance inevitably mean reverts.
Going the active route, entrusting that a strategy that takes into account changing fundamentals and valuation levels, and the impact thereof on future returns, can better manage the ever-changing landscape. An important characteristic of a properly risk-managed active approach is that unlike passive options, the risk of following the lemmings off the cliff can be greatly diminished.
As we consider the outlook for passive low-volatility approaches, warning signs abound. In the past month alone, we’ve come across reports from The Leuthold Group, Research Affiliates and JPMorgan questioning the wisdom of piling into this hot area of the market.
Looking at the valuation dispersion of a number of popular ETFs can shed additional light on this theme.
Advisors are faced with an interesting dilemma regarding multiple long-term factor payoffs, including low-volatility approaches. Although valuation is admittedly a useless short-term market indicator, ignoring valuations at their extremes could invite peril.
The solution may be to use individual stock selection through active management to gain exposure to factors like low volatility. After all, continuing to add to passive approaches that are blind to growing risk factors is to repeat the mistakes of the past.
According to Buddhist doctrine, it takes 10,000 years for a soul to evolve to its next level. Most investors have a slightly shorter time frame over which to learn from their mistakes and become more enlightened. Now might be a good time to start that process.