Before we kick off this week’s issue, we encourage you to check out Newfound Research’s Flirting with Models podcast which recently featured Omega Point’s Omer Cedar in which he discusses: how quantitative investors have impacted markets, how fundamental managers should think about factors, the low-hanging fruit for optimization, and surprising lessons he has learned in evaluating fundamental portfolios. We hope that you find it enjoyable and thought provoking.
Low Volatility Takes a Nosedive
Typically, the minimum volatility phenomena is driven by stocks with low Volatility exposure outperforming, not by high Volatility stocks underperforming. In other words, the strategy is to invest in low Volatility names rather than to short high Volatility names. To see this historically, we can dissect our high-minus-low (HML) Volatility portfolio from our past analyses into two long-only sub portfolios to represent high and low exposure to the factor.
If we’d invested in either portfolio in 2007, we would have made money over the 12-year timeframe. However, we would have made orders of magnitude more if we’d invested in the low Volatility portfolio - and herein lies the impetus for the low volatility investing phenomena.
Now, if we look at the 2020 YTD performance of these same portfolios, we see a wildly different trend.
On a YTD basis, the high Volatility portfolio (blue) returns over 10% while the low Volatility portfolio (purple) has a negative return of almost -22%! Not only is this a complete reversal to what we saw in the 2007-2019 period, but we would have lost a lot of money if we’d invested in the low Volatility portfolio at the beginning of 2020.
If the minimum volatility phenomena were forming for the first time today, the strategy very well could be to go short rather than long low Volatility.
Although high Volatility stocks are doing well on a YTD basis, the real story here is that the Volatility reversal is largely driven by low Volatility stocks underperforming. This points to a potential breakdown in the foundation for low volatility investing.
Is Volatility the New Bargain Sale?
One possible explanation for the reversal of high vs low Volatility is in how the market is speculating on cheap vs expensive names. Looking at the Value factor exposure within our high and low Volatility portfolios supports this theory. The Value factor represents the book-to-price ratio, so increasing Value indicates the portfolio is becoming cheaper while decreasing Value points to the portfolio becoming more expensive.
Turning to the low Volatility portfolio, this portfolio is generally more expensive, peaking at a Value exposure of 0.64 during the March market downturn and declining significantly to a current level of 0.
With high Volatility becoming cheaper and low Volatility becoming more expensive, investors are likely flocking to these high Volatility names that look more attractive than ever, especially in contrast to the low Volatility names.
|US & Global Market Summary|
US Market: 8/31/20 - 9/11/20
Normalized Factor Returns: Axioma Worldwide Equity Risk Model (AXWW4-MH)
Please don’t hesitate to reach out if you’d like to better understand your own portfolio’s relationship to Volatility or any other factors.