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Has Low Volatility lost its mojo?

Has Low Volatility lost its mojo?

21-12-2020 | インサイト
2020 has been a difficult year for Low Volatility investors and this year’s performance has been truly challenging, amounting to a period of soul searching. In this article, we share some of our reflections on 2020, contextualize this year from a historical perspective, before finally touching on our outlook on the future of Low Volatility investing.
  • Pim  van Vliet, PhD
    Pim
    van Vliet, PhD
    Portfolio Manager and Co-Head of Robeco’s Quantitative Equities department

Speed read

  • Lockdown impact explains unfavorable relative performance
  • 2020 has been a year of soul searching for Low Volatility investors
  • Selling Low Volatility stocks now would be a risky strategy
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The year 2020 has been a truly remarkable one. If we compare it with several other crises and market crashes, we can draw similarities with 1918 (Spanish flu pandemic), 1931 (global recession), 1987 (sudden market crash) and 1999 (stock market exuberance), but all fused at once. In such a volatile context, investors would have expected low volatility stocks to thrive. However, low volatility names did not offer much protection early in 2020 and have since lagged broad market indices by wide margins.

But in hindsight, the disappointing first-quarter performance can be explained by unfortunate exceptional circumstances. Lockdowns were required to control a looming global health care crisis, resulting in economic shutdowns that hit normally stable sectors, such as airports, hotels, insurance companies and shopping centers. As such, Covid-19 had an almost unprecedented impact on markets and on typical low volatility names.

Following the crash experienced in the first quarter of 2020, the market quickly rebounded. This rally was, again, largely driven by strong performance from a handful of online stocks such as the FAANGs. Meanwhile, many typical low volatility stocks, that had already been severely affected throughout the crash due to the impact of lockdown measures, proceeded to lag during the recovery, as the consequences of the pandemic continued to weigh on economic activity.

A year of soul searching

For low volatility investors, the lockdowns have been a period of soul searching and reflecting on why this type of approach actually works. Many pondered whether the investment style was still a good idea. Yes, it works over the long run– it has worked in every decade since the 1920s and it works within every country, it works within every sector. But is this time different? The late 1990s maybe provide a hint.

Between 1997 and 1999, stock markets rallied amid investor greed and irrational exuberance. They were also supported by the fear of the ‘millennium bug’ or ‘Y2K’, which triggered increased IT spending and supported the tech stocks of those days, in the same way that Covid-19 boosted the digital transformation of our economies. The powerful narrative of the 1990s instigated a low volatility stocks rout amid all of the tech excitement. With hindsight, we know the following years were prosperous for low volatility names

Figure 1 | Backtested rolling three-year alpha and excess return for US low volatility since 1929

Source: Robeco.com/data, CRSP. Sample period January 1929 - October 2020. The long-term portfolio data used is from Robeco.com/data. 80% of the low volatility portfolio consists of large low volatility names and the remaining 20% is made up of small low volatility equities. Stocks are sorted 2x3 based on size (above/below median NYSE) and three-year volatility. This database ends in December 2019 and the long-term low volatility portfolio is supplemented with the S&P Low Volatility Index for the year 2020.
The recent underperformance of low volatility stocks is therefore not ‘unprecedented’, and their mojo has already been lost before. Over the past 90 years, the three-year alpha of US low volatility stocks has been negative in 13% of all one-year periods, as Figure 1 shows. This was the case in 1932, 1967, 1975, 1980, 2000 and 2009. But after such weak performance periods, low volatility stocks usually came back stronger than before, making the case for a patient approach.

When the going gets tough

Unfortunately, many investors find three-year underperformance unbearable, especially when their job is to select the best managers and styles. The tendency is to sell, but often too late, while they also tend to miss out on strong reversals should they appear, because the average investor is not good at timing the market. Evidence shows that the difference between investor return (with timing) and investment return (no timing) is about -2% per annum.1 This explains why we are careful of style timing, especially when transaction costs are considered.

To illustrate this, we looked at the returns achieved by low volatility stocks after each year of three-year negative alpha over the full 90-year period. Although we should be careful not to derive strong claims based on a few independent observations, this may help us better understand return dynamics. In our exercise, we simply split the sample into two regimes: positive and negative past three-year alpha. Our calculations show that after a three-year negative alpha period, the expected three-year alpha rises from 2.7% to 5.7%.

Table 1 | Backtested three-year alpha 1929-2020

Source: Robeco.com/data, CRSP. Sample period January 1929 - October 2020. The long-term portfolio data used is from Robeco.com/data. 80% of the low volatility portfolio consists of large low volatility names and the remaining 20% is made up of small low volatility equities. Stocks are sorted 2x3 based on size (above/below median NYSE) and three-year volatility. This database ends in December 2019 and the long-term low volatility portfolio is supplemented with the S&P Low Volatility Index for the year 2020.

This alpha was missed by investors who gave up on low volatility when the three-year alpha turned negative. This explains why we believe it is crucial to stay invested when low volatility seems to lose its mojo, as low volatility returns tend to improve subsequently. Exiting when the going gets tough appears to be a regrettable and risky investment decision. Stay on course and be there to benefit from a potential recovery.

1 Strong hands, bridging the behavioral gap. Robeco paper November 2017.

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