an in depth look at the low volatility factor

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larryswedroe
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an in depth look at the low volatility factor

Post by larryswedroe » Fri Aug 19, 2016 7:16 am

http://www.etf.com/sections/index-inves ... strategies

Lots of new research on this factor

What's interesting is that the low volatility and quality factors have had premiums not just in stocks, but bonds as well.
Hope you find it helpful
Larry

DaufuskieNate
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Re: an in depth look at the low volatility factor

Post by DaufuskieNate » Fri Aug 19, 2016 7:48 am

Larry - Very good article. AQR uses a defensive strategy as one of their four styles in the Style Premia fund. How would you characterize their approach to the defensive style and does it take advantage of some of this new research?

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larryswedroe
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Re: an in depth look at the low volatility factor

Post by larryswedroe » Fri Aug 19, 2016 8:00 am

Nate
I have significant investment in the fund so that should speak for itself.
The biggest issue for me is that I have no doubt that low vol predicts low volatility, and it does so across assets. But valuations matter. And recent research shows that low vol in stocks has two regimes, one when it's growth and the other when it's value. When in growth you do get low vol, but lower than market returns and when in value regime you get the best of both worlds, higher returns and low vol.
The fund itself is defensive (so quality and low vol types of exposure) and across asset classes. And that factor mixes very well with the other factors. So that's why I'm invested
Hope that helps
Larry

gundlached
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Re: an in depth look at the low volatility factor

Post by gundlached » Fri Aug 19, 2016 10:36 pm

larryswedroe wrote:Nate
I have significant investment in the fund so that should speak for itself.
The biggest issue for me is that I have no doubt that low vol predicts low volatility, and it does so across assets. But valuations matter. And recent research shows that low vol in stocks has two regimes, one when it's growth and the other when it's value. When in growth you do get low vol, but lower than market returns and when in value regime you get the best of both worlds, higher returns and low vol.
The fund itself is defensive (so quality and low vol types of exposure) and across asset classes. And that factor mixes very well with the other factors. So that's why I'm invested
Hope that helps
Larry
Thanks for all you do Larry

Regarding low vol in growth regime, a lot of folks have been sounding the alarm that high valuations indicate the potential for significant losses in low vol. Do you believe that is true? By comparison to something like the S&P 500?

Should an investor be concerned that low vol will likely experience greater losses in a down market? Or is it just a reduced upside?

Thanks again.

stlutz
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Re: an in depth look at the low volatility factor

Post by stlutz » Sat Aug 20, 2016 12:13 am

Should an investor be concerned that low vol will likely experience greater losses in a down market? Or is it just a reduced upside?
I'm not Larry, but I would suggest backing away from the market-timing question (is XXX group of stocks going to drop in the near future?) and look at your question from a structural standpoint.

USMV has outperformed the S&P 500 in 2014, 2015, and so far in 2016. All three were up years in the market (2015 just barely). On the other hand, it underperformed in 2012 and 2013 (also up years of course).

Regardless of valuations, the behavior of 2012 and 2013 what you should expect in up markets for low volatility stocks. 2015 was the one year where low vol should have shone given the almost bear market that did happen that year. 2014 and 2016 (so far) are anomalies in the history of this type of strategy.

The market is usually going up. That means you should expect to underperform the market with a low vol stock strategy most of the time. The strategy pays off in down markets. As a strategy it looks very good over the past couple of decades as we had two historically large bear markets in that time.

Investors who are jumping into the strategy now expecting to beat the market most of the time will be disappointed--completely apart from any question of mean reversion.

Again, regardless of valuations, one should not expect low volatility to beat the market over the long term. The strategy is based on the idea of achieving maximum return relative to risk taken--returns slightly below the market but with about 1/3 less risk/volatility. For some folks, that's attractive; for many it's not.

If you are looking for the best absolute returns, those have historically been found with "mid vol" stocks. Of course there is no ETF focusing on such a thing, so you'd have to pick those yourself if you wanted to pursue such a strategy. :happy

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Re: an in depth look at the low volatility factor

Post by larryswedroe » Sat Aug 20, 2016 7:41 am

Gundlach
Based on the evidence the answer is no. The research shows that these stocks have lower volatility, thus in bear market they are likely to still have lower losses. Likely is the key word. But it is not a guarantee.
I would add that the evidence is that low vol stocks have exposure to term risk, which is logic as they have more stable cash flows. So let's imagine a bear market caused by rising real rates and rising inflation. That might lead to worse performance due to the exposure to term risk. At least should be aware of that risk

And would add that the recent outperformance in bull markets is of course due to the large inflows, which has two effects, first raising historical returns and then lowering future returns as the first is one time event which caused valuations to rise,
Larry

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Re: an in depth look at the low volatility factor

Post by FIREchief » Sat Aug 20, 2016 11:56 pm

larryswedroe wrote:http://www.etf.com/sections/index-inves ... strategies

Lots of new research on this factor

What's interesting is that the low volatility and quality factors have had premiums not just in stocks, but bonds as well.
Hope you find it helpful
Larry
Larry - I tried to understand your article (as I normally do). What should be my take away? What does this mean for my portfolio?
I am not a lawyer, accountant or financial advisor. Any advice or suggestions that I may provide shall be considered for entertainment purposes only.

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larryswedroe
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Re: an in depth look at the low volatility factor

Post by larryswedroe » Sun Aug 21, 2016 8:17 am

Firechief
Maybe nothing unless you or your funds invest in the low vol factor.
But let's assume you do. What this means is that because the low val factor has become so popular, or crowded, the valuations have been pushed so low vol stocks are now in a "growth regime" meaning that they are now growth stocks in terms of their valuations.

The research shows that low vol does predict future low volatility. So that is not impacted by valuations. However, when in growth regime low vol produces well below market returns as the trade off for the lower vol. However, when low vol is in value regime it not only predicts low vol it predicts above market returns, the Holy Grail. Historically low vol has spent 62% of the time in value regime and 38% in growth. So it's highly time varying.

I'll add this. The research does show that low vol to a great degree is explained well by other factors including TERM risk (they are more bond like, more stable cash flows, hence the low vol) and also quality stocks, as well as obviously by value. Thus if you have a fund that screens by both quality/profitability and value you are IMO likely better off than with just low vol. And if exposed to low vol should take that into account when thinking about duration risk of your portfolio, so should likely lower your TERM risk with your bonds to offset the TERM risk of the low vol stocks. (or at least account for it).

I hope that is helpful

Note my new book Your Complete Guide to Factor Based Investing will go into all of the above issues from the research. Andy Berkin and I cite more than 100 academic papers in the book, which should be out by year end. We've been lucky enough to have a bunch of top finance professors and professionals review the book, making it as strong as we can.

Best wishes
Larry

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Re: an in depth look at the low volatility factor

Post by boglerdude » Sun Aug 21, 2016 9:45 pm

Larry, how many years are managers allowed to underperform the index, before they get outflows?

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larryswedroe
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Re: an in depth look at the low volatility factor

Post by larryswedroe » Mon Aug 22, 2016 7:40 am

Bogleduds

That's up to investors, but good example is Fidelity Magellan has been underperformer basically since Lynch left, and outflows have occurred but fund still has $15B, way down from when it was largest fund in world. But typically funds get outflows fairly quickly as investors are performance chasers. For institutional investors typical to evaluate every three years.
Larry

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