Tag Archives: performance

Low Volatility Funds Outperform In 2016

In July and August of 2015, I wrote an expansive series of fourteen articles on the Low Volatility Anomaly, or why lower risk investments have outperformed higher risk investments over time. This Anomaly seems paradoxical; investors should be paid through higher returns for securities with a greater risk of loss. Across different markets, geographies, and time intervals, the series shows that higher beta investments have not delivered higher realized returns and offers suggestions backed by academic research to suggest why this might be the case. We are in another period where lower volatility stocks are dramatically outperforming higher beta stocks, and this article will demonstrate the relative performance of these strategies year-to-date. I will demonstrate the relative performance across capitalization sizes (large cap, mid-cap, and small cap equity) and other geographies (international developed and emerging markets). Readers may counter that, of course, lower risk stocks are outperforming in a down market, so I will show relative performance of the indices underpinning these strategies back to the March 2009 cyclical lows. If lower volatility strategies capture less upside in bull markets, then perhaps their value in corrections is overstated. Let’s look at the evidence. Year-to-Date Performance: Large-Cap Thus far in 2016, the two most popular low volatility exchange-traded funds, the iShares MSCI USA Minimum Volatility ETF (NYSEARCA: USMV ) and the S&P 500 Low Volatility Portfolio (NYSEARCA: SPLV ) are handily beating the S&P 500 (NYSEARCA: SPY ), the broad domestic equity market gauge. Through Friday’s close, the S&P 500 has generated a -8.46% total return while the most popular low volatility funds have lost just over three percent. Relative performance is graphed below: Click to enlarge Source: Bloomberg; Standard and Poor’s Year-to-Date Performance: Mid-Cap Mid-cap stocks have further underperformed large cap stocks thus far in 2016 with the SPDR S&P MidCap 400 ETF (NYSEARCA: MDY ) producing a -9.57% return. The low volatility subset of this index, replicated through the PowerShares S&P MidCap Low Volatility Portfolio (NYSEARCA: XMLV ) has also meaningfully outperformed in 2016, besting the mid-cap and large cap indices. For a historical examination of the risk-adjusted returns of this index, see my article on ” The Low Volatility Anomaly: Mid Caps “. Click to enlarge Source: Bloomberg; Standard and Poor’s Year-to-Date Performance: Small Cap Like both large and mid-cap stocks, the PowerShares S&P SmallCap Low Volatility Portfolio (NYSEARCA: XSLV ) has meaningfully outperformed the S&P 600 SmallCap Index ETF (NYSEARCA: IJR ). While the exchange-traded fund has a limited history (February 2013 inception date), the underlying index has data back for twenty years, demonstrating a return profile that would have bested the S&P 500 by nearly four percentage points per annum with lower variability of returns. This fund may deliver both the “size premia” and the “low volatility anomaly” in one vehicle, and has acquitted itself decently (543bp outperformance versus small caps and 307bp outperformance versus the S&P 500) in a rough market start to 2016. For a historical examination of the risk-adjusted returns of this index, see my article on ” The Low Volatility Anomaly: Small Caps “. Click to enlarge Source: Bloomberg; Standard and Poor’s Year-to-Date Performance: International Developed Negative equity market performance has obviously not been unique to the United States amidst a global sell-off. The PowerShares S&P International Developed Low Volatility Portfolio (NYSEARCA: IDLV ) has outperformed non-US developed markets, besting the Vanguard FTSE All-World ex-US ETF (NYSEARCA: VEU ) by 450bp in 2016. Click to enlarge Source: Bloomberg; Standard and Poor’s Year-to-Date Performance: Emerging Markets Pressured by the spillover from decelerating Chinese growth, commodity market sensitivity, and increased market and currency volatility, emerging markets have been a focal point for stress in 2016, but the PowerShares S&P Emerging Markets Low Volatility Portfolio (NYSEARCA: EELV ) has meaningfully outperformed the two largest emerging market exchange traded funds – the Vanguard FTSE Emerging Markets ETF (NYSEARCA: VWO ) and the iShares MSCI Emerging Markets ETF (NYSEARCA: EEM ). Click to enlarge Source: Bloomberg; Standard and Poor’s In past articles, I have often demonstrated the efficacy of Low Volatility strategies by showing the relative outperformance of the S&P 500 Low Volatility Index (NYSEARCA: SPLV ) versus the S&P 500 and S&P 500 High Beta Index (NYSEARCA: SPHB ). The Low Volatility bent produces both higher absolute returns and much higher risk-adjusted returns. Click to enlarge Readers might look at these cumulative total return graphs and believe they can time the points at which high beta stocks outperform. From the close of the week at the cyclical lows in March 2009 to Friday’s close, the Low Volatility Index has also outperformed on an absolute basis. Click to enlarge In a long bull market that saw 16%+ annualized returns, you have not conceded performance when including the recent correction. In addition to less variable returns over time, low volatility strategies also afford more downside protection – an important feature that has been valuable in early 2016. 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 SPY, SPLV, USMV, VWO, IDLV, XSLV, IJR. 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.

True Value Investing Still Works

Value investing is on the ropes. At least, that’s what you’d think reading articles like this one that highlight how “value” has underperformed “growth” in recent years. I put those words in quotes, partly because the distinction between value and growth is somewhat arbitrary , and also because the critics of value investing tend to attack metrics that have no real connection to shareholder value creation. Patrick O’Shaughnessy did a great job of attacking this myth on his blog, The Investor’s Field Guide . He points out that, over the last ten years, investors that have bought the cheapest stocks based on price to accounting book value have significantly underperformed. As we recently pointed out , book value relies upon flawed accounting metrics, diminishing its usefulness for investors. Unfortunately, most of the “value” indexes that people reference, such as the Russell 3000 Value Index, are based primarily off of price to book. As O’Shaughnessy points out, the performance of value strategies varies greatly depending on which metric you use. If you picked the cheapest stocks based on earnings, you did poorly in 2015 but slightly overperformed over the last decade. Stocks with the cheapest price to sale ratios have done very well recently. Despite their superior recent performance, these metrics have their own problems. We’ve pointed out many times how price to earnings ratios are inherently flawed and have almost no relationship with actual value. The sales number is at least less easy for executives to manipulate, but it also ignores structural margin differences and the impact of the balance sheet. What’s The Solution? Investors looking for value need to take a holistic approach that measures a company’s ability to deliver economic earnings to investors and quantifies the expectations for future cash flows embedded in its current stock price. This is what New Constructs aims to do, and while that process is not easy, it can be rewarding, as shown by the long-term outperformance of our strategies . As you can see from Figure 1, over the past decade our Most Attractive Large and Small Cap stocks have outperformed a combination of the S&P 500 and Russell 2000 by 80%. Figure 1: Most Attractive Stocks Outperform Click to enlarge Sources: New Constructs, LLC and company filings. The diligence we do helps us to uncover hidden gems that might not show up in simplistic, traditional value screens, such as computer chip manufacturer NVIDIA (NASDAQ: NVDA ). When we highlighted NVDA as a long idea in September, it had a P/E of 24 and a P/B of 3. Hardly numbers that are going to make your “average” value investor salivate. However, a closer look showed that these numbers were misleading. For one, NVDA’s reported income was artificially depressed by a $60 million write-down hidden in the footnotes . Plus, the company earns a fantastic return on invested capital ( ROIC ) of 34%, demonstrating its competitive advantage and its ability to efficiently allocate capital. After making adjustments to determine the true earnings quality and quantifying the market’s expectations for future cash flows, we saw that NVDA had a price to economic book value ( PEBV ) of just 1.1, implying that the market believed the company would only grow after tax operating profit ( NOPAT ) by 10% for the remainder of its corporate life. For a company that had just doubled its NOPAT the year before, those expectations seemed awfully low. Sure enough, the market has adjusted its expectations for NVDA in the past few months, driving the stock up 25% even as the S&P 500 has fallen by 2%. When the markets get volatile, it’s the real value stocks, the ones with economic profits and low market expectations, that thrive. Meanwhile, the imposters get exposed. Avoiding Value Traps and Imposters Succeeding in a struggling market is as much about avoiding the bad stocks as it is about picking the good ones. Our research helps clients avoid “value traps” that seem like they might be cheap on the surface but are actually significantly overvalued when you look a little closer. One such value trap we warned investors about was Olin Corporation (NYSE: OLN ) back in June of 2014. The stock had a P/E of 13 and a P/B of 2 at the time, but those numbers were highly misleading. Hidden non-operating items boosted its reported earnings by $25 million. Plus, the company was facing obvious headwinds in the form of falling commodity prices for its chemicals division and an unsustainably high level of demand for its Winchester ammunition segment. Despite this fact, the market was expecting that OLN grow NOPAT by 5.5% for 35 years, an unrealistically long timeframe for such a weak and highly commoditized business. OLN was able to coast by on its inflated accounting earnings when the market was strong, but that all changed after the S&P 500 hit its peak in the spring of 2015. Since then, the stock’s been in free fall, and it’s now down 42% from when we made our Danger Zone call. Investors that pick stocks like OLN and ignore ones like NVDA due to simplistic metrics are not truly value investors. In a buyer-beware system like our market, you need to understand how to separate real value-investing research from the imposters. True value investing means performing your due diligence to understand the real economics of the underlying business and the profits it will have to achieve in the future to justify its stock price. Only by doing this hard work can investors uncover value and protect their portfolio. Disclosure: David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, style, or theme. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Risk Rotation Portfolio: A Strategy For Retirement Accounts

Summary What is the Risk Rotation portfolio? How to construct and manage a Risk Rotation portfolio inside a 401K type of account. How does a Risk Rotation portfolio perform compared to the broad market? What is the Risk Rotation Portfolio? The Risk Rotation (or Asset Rotation) portfolio is not something new. One can find many variations for such a portfolio on the Internet. In the SA community, you can find several articles and contributions on similar and other Asset Allocation strategies by Frank Grossmann , Varan , Joseph Porter and others. In brief, the core principle in a Risk (or Asset) Rotation portfolio is to periodically move (or rotate) assets out of an asset with a higher downside risk to an asset that has lower downside risk and higher upward momentum. Such a portfolio aims to provide much lower volatility and drawdowns while capturing similar (or better) returns as the broader market. Though such a portfolio can be constructed inside any brokerage account, I personally find them more appropriate for retirement accounts. Risk Rotation portfolio for retirement accounts Investing successfully has never been easy. Even for the most disciplined investors, the market’s volatility sometimes takes its toll. The past few months have been an emotional rollercoaster for many folks, especially for those closer to retirement. If your horizon is very long term, this is simply market noise and best be ignored. However, for anyone who is already retired or close to retirement, any sharp correction has the potential to derail their near and medium-term planning. The big question is how do you protect yourself from a market downturn or an outright crisis like the one we had in 2008? Furthermore, most retirement accounts like 401K accounts do not provide the flexibility to buy individual stocks or even ETFs (Exchange Traded Funds). A vast majority of them provide just a handful of funds to invest. So, you cannot select your own dividend paying stocks and follow a DGI strategy. In my opinion, one good option is to construct a Risk Rotation portfolio. In my own experience, and also based on back testing, such a portfolio will provide market-beating returns in most situations while providing a high degree of risk protection. A disclaimer: I am also a believer in DGI strategy, and personally invest the majority of my investible funds in individual stocks that pay and grow their dividends. However, for accounts where I cannot invest in individual stocks, I follow the Risk Rotation strategy for about 50% of such assets. If you are interested in my other portfolio strategies, I publish a ” Passive DGI Portfolio ” and another portfolio that is Income-centric named ” The 8% Income Portfolio ” on SA. How to construct a Risk Rotation portfolio: I believe in keeping things simple so they can be easily followed long term. As an example in this article, I will use two securities (a pair of two securities). This pair can be easily implemented inside a 401k type account with moderate risk. There can be more aggressive pairs or strategies that promise higher returns (with higher risk obviously), but they cannot be easily implemented inside a retirement account. Moderate Risk strategy: SPY and TLT pair SPDR S&P 500 ETF (NYSEARCA: SPY ) is an ETF that corresponds to the price and yield performance of the S&P 500 Index. Almost all of the 401K or retirement accounts would offer something that is equivalent of S&P500 index. SPY is taken as an example to illustrate, but any similar fund or ETF can be used in place of SPY. iShares 20+ Year Treasury Bond (NYSEARCA: TLT ) is a 20+ year Treasury fund and oftentimes provides the inverse co-relation with stocks. One can find something similar to TLT inside a retirement account. If nothing similar is available, it could be replaced by cash or cash-like money-market funds. However, the back-testing results by using cash are not as impressive as with TLT. One reason is that TLT provides some yield and at times meaningful appreciation, but cash provides neither (though money market funds do provide some minimal yield). On the first of every month, compare the performance of each of the two funds with a 3-month (or 65 trading days) look-back period. – Invest 70% of the allocated amount in the fund that has better performance over the last 3 months – Invest 30% of the allocated amount in the fund that has worse performance over the last 3 months – If the look-back period performance has been the same or nearly same, invest 50% in each of the two securities. – Repeat every month, on a fixed date of the month. It can be 1st of the month or any other date. Low Risk strategy: SPY, TLT and Cash For more conservative investors, a strategy that involves adding cash to the basket (SPY and TLT) will work a little better. This will also work better during times when both stocks and Treasuries are headed down. This strategy will provide much lower drawdowns, however, at the cost of some performance or overall returns. – On the first of every month, compare the performance returns of each of the three funds with a 3-month (or 65 trading days) look-back period. Performance of cash being taken as 0%. – Invest 60% of the allocated amount in the fund that has better performance over the last 3 months – Invest 30% of the allocated amount in the fund that has second worse performance over the last 3 months – Invest 10% of the allocated amount in the fund that has worst performance of three funds over the last 3 months – Repeat every month, on a fixed date of the month. It can be 1st of the month or any other date. Performance comparison: RRP Strategies vs. S&P 500: (click to enlarge) Image1: Performance/Returns – RRP Strategies vs. S&P 500 The table above shows the performance/returns of the Risk Rotation portfolio (RRP) starting with the year 2006. Row 12: Shows how the portfolio would have performed versus S&P 500 if we had invested $100,000 on January 1, 2006 and remained invested until 10/30/2015. Row 11: Shows how the portfolio would have performed versus S&P 500 if we had invested $100,000 as of January 1, 2007 and remained invested until 10/30/2015. And so on… Notice, except for two starting years (2012 and 2013), the RRP either matches or handily beats S&P 500 with much lower drawdown. The main benefit that stands out is that it moves the portfolio away from the risk in a crisis situation that we witnessed in 2008. I did not go back to the year 2001-2002, but I expect similar behavior. (click to enlarge) Image2: Growth of $100,000 starting on 1/1/2006 – RRP strategy vs. S&P 500. (click to enlarge) Image3: Monthly drawdowns since year 2006 – RRP strategy vs. S&P 500. (click to enlarge) Image4: Maximum drawdown since year 2006 – RRP strategy vs. S&P 500. Risks from this strategy: Let’s consider some potential risks: The first risk comes from the fact that we are seeing the performance comparison based on back-testing results. As the adage goes, past performance is no guarantee of future results. TLT or any other equivalent fund would invest in a treasury based bond fund. In a rising interest rate environment, TLT may have inferior performance compared to past. However, this risk should be mitigated by the fact that we are checking the performance of the two securities every month and switching if necessary. Lack of Diversification: For the stocks component, we are investing in SPY (equivalent of S&P 500), so there is not much exposure to any of the international markets or other asset types like gold or commodities. However, this is partially mitigated by the fact that the companies inside S&P 500 earn a lot of their revenue from outside of the US. Another risk comes from the fact that oftentimes, the performance of this portfolio will be different than the broader market. If it happens to be negative compared to the broader market for a couple of years, the investor may lose conviction and the discipline and may abandon the plan mid-course. This probably is the biggest risk. Concluding Remarks: As they say, hindsight is 20:20. It is hard to predict with any certainty that such a strategy will work as well as it has worked in the past. That’s why it is important to not keep all of your eggs in one basket and depend too much on any one strategy. In my opinion, for the long haul, this strategy should at least match S&P 500 performance with much lower drawdowns, and hence should allow much better sleep at night. I am starting out a sample portfolio with $100,000 initial capital allocated as of November 3, 2015 and will provide regular updates. I plan to publish the performance comparison of the two securities (SPY and TLT) with the previous 3 months’ look-back period on or after the first trading day of every month. This will indicate if a switch of assets is required for the strategy. Here is the relative performance of SPY and TLT as of November 2nd with 3-month look-back period: Price (adj. close) on 11/02/2015 Price (adj. close) on 7/31/2015 Performance/Return Over last 3 months TLT 121.95 121.75 0.16% SPY 210.33 209.36 0.46% Source: Yahoo Finance Since the performance is nearly the same for both, the strategy will invest 50% of $100,000 in each of the two securities. Full Disclaimer: The information presented in this article is for information purpose only and in no way should be construed as financial advice or recommendation to buy or sell any stock. Every effort has been made to present the data/information accurately; however, the author does not claim for 100% accuracy. The portfolio or other investments presented here are for illustration purpose only. The author is not a financial advisor, please do your own due diligence.