Sat, 10 Sep 2016
Combining low volatility and momentum factors can be beneficial from a diversification perspective, says Craig Lazzara of S&P Dow Jones Indices.
Jason Kephart: Hi, I'm Jason Kephart, an alternative strategies analyst at Morningstar. I'm joined today by Craig Lazzara, head of index investment strategy at S&P Dow Jones Indices.
Craig, thanks so much for joining me today.
Craig Lazzara: Jason, glad to be here. Thank you.
Kephart: So, one of the big themes we've seen in ETF land is the rise of factor investing, and no factor has been more popular to the beginning of the year than low-vol. Can you explain a little bit about what low volatility is and why do you think it's become so popular?
Lazzara: Low volatility is one of a set of what we would call factor indices, just as you do. Low volatility really stems from an observation. The observation is that, in theory, portfolios of high-volatility stocks should have higher expected return, should have higher returns than portfolios of lower-volatility stocks. That's what the capital asset pricing model predicts, that's what we all learn in elementary finance--we learned that risk and return are connected. And the observation that counters that theory is that it just doesn't work that way, that in fact high-beta or high-volatility stocks underperform what you would expect, and low-volatility stocks do better. So that observation has given rise to a number of investment strategies, which over the course of the past five years or so have been "indicized," as I like to say, into low-volatility indices.
They have a couple of advantages. One is that they deliver, what I like to call, the two P's: protection in declining markets, that's not complete protection but typically if the market is bad, you go down less; and participation in rising markets, not full participation either, but if the market rises, you'll typically participate as well. And that's a very congenial pattern of returns for a lot of investors because it cuts off the worst of the downside and still gives you access to some of the upside. So that observation years ago, which gave rise to this pattern of returns, and what we've had so far in 2016, has been a relatively choppy market, certainly in the early part of the year, low volatility's defensive characteristics were very important then and the indices have all done quite well.
Kephart: And low-vol is just one factor, right? Are there other factors investors should be considering or when you're thinking about building a portfolio, are there certain factors that work particularly well with low volatility?
Lazzara: Well, there are a range of factors. I mean, the best way to answer that question, Jason, is to say, well, think back to Fama and French in 1991 who--they weren't the first to do this--but to notice that small size and cheap valuation were factors of return. I mean, when I say factor, I mean a quality with which excess returns are associated. Momentum is certainly a factor. There's good academic documentation for that. I would argue low volatility goes into that category, quality maybe. So there may be five, six, seven factors. There aren't 100, there aren't 50. There may be a 100 different manifestations because you can say, well, I can capture value by earnings/price ratio or book/price or sales/price or a dividend discount, lots of ways to do it. But the basic factors are relatively few, I think, in number.
In terms of low volatility, if you look, at least in our data, at the correlation of low volatility's excess returns with the excess returns of these other factors that we mentioned, the one that's particularly striking is low volatility and momentum because momentum does not perform well at the same time low-vol does. So those are a reasonably good pairing if I had to use that term. Whereas if you put low volatility with quality, there's nothing wrong with doing that, but you don't get nearly as much diversification from doing so as you do with momentum.
Kephart: And so, do you think investors should be putting more emphasis on trying to find the right factor or maybe looking at something like a multifactor approach?
Lazzara: It depends, as most things in investment do, right, it depends. And what it depends on in this case is how comfortable investors are with the return pattern that any factor index gives you. Now, low-vol is a good example because low volatility very reliably if the market is down a lot, it's highly likely to outperform; if it's up a lot, it's highly likely to underperform and the middle is less distinct but still pretty good performance then as well.
What that means is that over long periods of time, at least, this has historically been the case, and I think good reasons to suppose it will persist, but over long periods of time low-volatility investors have been able to realize not only better risk-adjusted returns compared to a neutral benchmark like the S&P 500, but higher absolute returns as well. The price of earning those higher returns is that you expect to lag in rising markets. So, from the standpoint of an investor, if you're OK with that, and I tell financial advisors all the time, if you have a client who when the market's up 30% one year and you are only up 20%, is going to be mad and fire you, then don't do this because that's what low volatility is designed to do.
Now, if you as an investor can accept that pattern of, I'm willing to underperform a strong market, maybe for several years in a row--it happened in the late '90s--I'm willing to underperform in exchange for the downside volatility attenuation and the long-term factor premium, low-vol is a great fit in those circumstances. If you are less comfortable with that, then maybe it's appropriate to think about combining low-vol with momentum, say, which will diminish the underperformance in strong years although it won't perform as well in bad years. So, it really all depends.
Kephart: So, low-vol momentum pair pretty well together. Quality, it seems like, at least on the surface, has a lot of similarities with low volatility. Should investors be wary about pairing those two together?
Lazzara: I wouldn't say wary, but the benefits from doing so, at least in our work, would not be nearly as great. I'm saying this from the standpoint of assuming that an investor has a low-vol position and is thinking what might be useful to add to that. Quality, it won't hurt. Over long periods of time quality has also paid off. It has similar pattern to low-vol in that it attenuates volatility rather than enhances volatility. So, it will also tend to underperform in rising markets and tend to outperform in falling markets. You get some diversification benefit but not all that much. Momentum, on the other hand, because it's what I would call a volatility enhancer, it will tend to outperform in rising markets and underperform in falling markets is a better blend with low-vol in my view.
Kephart: OK. And then, I guess, lastly, given the performance we've seen of low-vol ETFs this year, what expectations should investors have kind of going forward over the next, say, 12 months for the strategy?
Lazzara: Well, the best predictor that I know of the relative performance of low-vol is the absolute performance of the S&P 500, I mean, assuming we're talking about big-gap low-vol. If you could predict what the S&P 500 will do, I can give you a pretty good guess as to what low-vol will do. But of course, if you could predict what the S&P 500 will do, you wouldn't worry about low-vol to begin with. So, what I would tell investors is don't try to predict the factor. If it fits your preference for risk and return, if you're comfortable with the notion of upside participation and downside protection, low-vol may well be a good fit, and you needn't overthink it beyond that. If you're not willing to give up some of the upside and you're not particularly concerned with the downside, then maybe it's not for you. But for those investors where that volatility attenuation is congenial, it's quite a good fit.
Kephart: Great. Well, thank you so much for joining us today.
Lazzara: Thank you.
Kephart: We very much appreciate it. With Morningstar, I'm Jason Kephart.