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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.

Be A Proactive Investor

During volatile times in the market, like what we have been experiencing since May, it’s difficult to see through the disparaging news headlines (Oil is Collapsing! Bear Market in Stocks! US Is In A Recession!) and to not lose the forest for the trees. Investing is a long-term game with seemingly unlimited number of opportunities and it’s imperative as an investor to not get caught up in the day-to-day swings (and explanations) of the stock market. It’s times like this where a word like “casino” gets tossed around as a synonym for the stock market. And you know what, in the short run, the market is a lot like a casino. One day the market is up, the next day the market is down. Don’t believe me since it feels like the market has been down a whole lot more than it has been up lately? Well, would you be surprised to know that over the past 200-days developed world equities have been up 47% of the days and down 53% of the days. Pretty close to a 50-50 coin flip, right? Percentage Of Positive Performance Days For Stocks Proactive Investor But long-term investors know that the stock market isn’t really like a casino at all. The “payoff odds” in the stock market are not static like they are in a casino. Hitting the right number in roulette will always pay 35:1 but investing in the right stock could return 10% or it could return 10,000%. Therefore, it’s key to think of investing in terms of probabilities instead of binary outcomes. Investing is not about calling the top or bottom in the market exactly right. It’s about understanding if there are more positive investment opportunities in the market than there are negative opportunities (or vice versa). Put another way, it’s about properly identifying where the market currently falls on the risk/reward spectrum. This way, you as an investor can be proactive rather reactive to changes in the market. We have known for quite some time that this is the longest running cyclical bull market in a secular bear market , so a selloff like the one we are in now was bound to happen sometime. And in the long term, that is actually great news for investors because future returns have undoubtedly improved thanks to the opportunity to buy stocks on “sale.” But this is where investor psychology really comes into play. If your risk antennae was not tuned up to the fact that the probability of a selloff had increased (i.e. the opportunity set had shifted from more buying opportunities to more selling opportunities), then it’s really difficult to realize after a 15-20% decline that the opportunity set is ALREADY shifting again back into your favor. You are reacting to the declining market and when you are reacting, it’s hard to make the correct rational decision. To sell stocks into a declining market is always hard because in the back of your mind you know you missed out on the optimal time to get out and it’s so easy to tell yourself “I’ll sell out of stock XYZ just as soon as it rises 5-10%.” Of course, in a slide like we are in now, it’s very rare for the market to ever give you that 5-10% gain, and so you sit on the underperforming stock far longer than you would have liked. However, if an investor is proactive in identifying where we currently sit on the risk/reward spectrum, there is a very good chance that that investor had begun to shift his or her portfolio into more defensive sectors and perhaps into cash as well. While they would have been undoubtedly early and missed out on some of the gain back in May, they are already mentally prepared to begin to take advantage of some of the positive opportunities that are presenting themselves in this correction. This is why at Gavekal Capital, we focus so much on risk management. Yes, risk management is about protecting the downside. But more so, it’s about being proactive in your investment process so that when the risk/reward spectrum flips in your favor you are ready to take advantage of it and capture the gains in your portfolio. Disclosure: None.

5 ETFs For Portfolio Safety, Stability And Diversification

Global stock market volatility, oil price collapse and economic slowdown in China continue to rattle investor confidence this year. Former high flying stocks have come back to earth in the past few weeks as investors worry about the impact of weak global demand on corporate earnings. Investors had poured a lot of money into these stocks despite their sky high valuations but “risk-off” sentiment is sending many to “safer” assets now. As the domestic economy continued to recover slowly but steadily over the past few years, US stocks remained one of the best asset classes in the world. But of late, domestic economic growth has been rather uneven. In the current uncertain market environment, it would be better for investors to focus on capital preservation. Below we have discussed some ETFs that will not only provide stability and diversification to your portfolio but also help in capital preservation. Long-Term Treasury Bonds The Federal Reserve spent the last year prepping the markets for a rate hike for the first time in almost a decade and ultimately raised rates by 25 bps in December and also penciled in four rate hikes this year. The market however expects not more than one rate increase this year. So, bond markets continue to frustrate bears again. Longer-term bonds are impacted more by inflationary expectations than by monetary actions and with expectations so muted, the bullish trend for these ETFs is likely to continue. Then while rates are low here in the US, they are much lower in the other parts of the developed world. In Europe and Japan, monetary authorities are expected to continue easing in order to fight deflationary risks. So, compared with those interest rates, US interest rates are still very attractive for foreign investors. 25+ Year Zero Coupon U.S. Treasury Index Fund (NYSEARCA: ZROZ ) ZROZ follows the BofA Merrill Lynch Long US Treasury Principal STRIPS Index, which focuses on Treasury principal STRIPS that have 25 years or more remaining to final maturity. It charges just 15 basis points in expenses while the 30-day SEC yield is 2.53% currently. iShares 20+ Year Treasury Bond ETF (NYSEARCA: TLT ) TLT tracks the Barclays Capital U.S. 20+ Year Treasury Bond Index. It is the most popular and liquid ETF in the space with AUM of over $9.4 billion and excellent daily trading volumes. The fund charges 15 bps in expense ratio while the 30-day SEC yield is 2.34% currently. Both these ETFs have Zacks ETF Rank #2 (Buy). Gold On Monday, gold recorded its biggest daily gain in more than 14 months as a strong risk-off sentiment continues to force investors to pile into the safety of the precious metal. Additionally, a falling dollar (commodity prices generally move inversely to the dollar) and rising demand in China and India-the two biggest consumers of gold in the world-have also been helping gold’s ascent. Chinese investors in particular have been buying gold lately as the country’s stock market and currency continue to swoon. Negative interest rates in some of the major countries are also boosting gold prices. Gold critics often argue that the “barbarous relic” is an unproductive asset since it pays nothing to holders and that argument does make some sense when interest rates are high but not in the ultra-low/negative interest rate environment. iShares Gold Trust (NYSEARCA: IAU ) IAU provides a convenient and cost-effective access to physical gold. It is a physically backed ETF with more than $5.2 billion in assets. The fund has beta of -0.23 with the S&P 500 index and adds diversification benefits to an equity focused portfolio. SPDR Gold Trust ETF (NYSEARCA: GLD ) GLD is the most popular gold ETF with almost $29 billion in AUM and excellent trading volumes. It is a physically backed ETF that charges 40 basis points in annual expenses. While IAU has a lower fee, GLD’s excellent trading volumes make its trading very cheap. So, IAU is more suitable for buy and hold investors while GLD is better for trading portfolios. Municipal Bonds Municipal bonds were one of the best performing asset class in the US fixed income space last year. There are many factors that suggest that they may continue to outperform this year as well, including decreasing supply, rising tax rates and juicy income yields in the current ultra-low rate environment. Municipal bonds supply as of the end of last year was about $400 billion , boosted mainly by refunding issuances in anticipation of higher interest rates. Experts expect the supply to decrease by about 25% this year. iShares Muni Bond ETF (NYSEARCA: MUB ) MUB is the most popular ETF in the municipal bond space with more than $6.1 billion in AUM. It charges 25 bps in expenses and has a 12-month yield of 2.49%. The income is exempt from federal taxes and the Alternative Minimum Tax (AMT). The product provides a convenient access to more than 2000 investment grade municipal bonds. The Bottom-Line During times of turmoil, it is most important for investors to stay focused on their longer-term investing goals. Further, it is beneficial to stay diversified as history has shown us diversified portfolios always have better risk-adjusted returns over longer periods. Original post