Factor Derby Recap: Low Volatility Hangs on in Photo Finish
June 1 marked the start of OppenheimerFunds’ inaugural Factor Derby competition, which offered participants a chance to test their factor investing acumen over a three-month “race” period, with the winner earning $25,000 for charity. With the results now in, we’ve crowned a single champion, who placed an all-in bet on the low volatility factor to win the race.

Across the board, 11% of Factor Derby participants chose a single factor to win, defying recent evidence that a multifaceted approach may lead to improved outcomes by harnessing factor diversification. We witnessed a love for momentum among “all-or-nothing” entrants, with half of them throwing their entire portfolios into the high-octane factor for the three-month sprint.

Among the practitioner community, which includes financial advisors, RIAs, and institutional investors, the quality factor was the only one that did not receive a single “all eggs in one basket” entry. This is rather surprising given the wily veteran’s long-term strength of 1.93% average annualized outperformance relative to the market over the past 10 calendar years. We also are surprised from a forward-looking angle, as quality stocks look poised to benefit from multiple macroeconomic and market trends, such as yield curve flattening.

Overall, the average submission devoted roughly one-third of the portfolio to the momentum factor. Based on behavioral biases, this may not be surprising given the factor had a tremendous handicap coming into the gates, having outperformed the broad market by nearly 5% over the trailing 1-year period at the start of the Derby.

On the other hand, the low volatility factor garnered the least interest of all the factor horses, receiving an average portfolio weighting in the low double-digits. This can perhaps be explained by the factor’s repeated bobbles in the year leading up to the Derby’s start, during which it underperformed the market by more than 4%. But with global risk appetite starting to wane, this may have been a classic example of an underlay – a horse racing at shorter odds than seems warranted by his/her past performances.

Results Overview – A Three-Lap Sprint

Each month of the race had a clear and distinct winner. Let’s go lap-by-lap and see how results shaped up.

Exhibit 1: Factor Performance During Each Leg of the Sprint

The first leg saw tight dispersion, with slightly over 1% in returns differentiating the first- and last-place horses. The small company factor edged out quality to take the lead through the first third of the sprint. June’s markets were driven by continued momentum related to USD strength, and small caps posted their fourth straight month of outperformance relative to large caps, a trend that started at the beginning of March. While small companies started the race at a fast pace, value was pushed to an outside position in favor of quality, consistent with a theme that has been in place over the past few years.

The second leg saw a rotation away from recent winners, as momentum and quality both underperformed the market in July. The top factors during the month were low volatility and value, both equity factors that have been largely out of favor. Small companies found themselves on the losing part of this recent winner rotation, with nearly 1.5% of underperformance relative to the market, and their first-to-worst reversal left the factor stranded heading into the final leg.

The pack moved around the turn into August and geared up for the final stretch. June’s factor winners came back in vogue, as momentum, quality, and small size outperformed yet again. Value trailed significantly, but low volatility’s strong July and market-like performance in August kept it in the running.

And the Winner Is … Low Volatility!!

The factors ended the race in a photo finish, with only 32 basis points separating first-place low volatility and the runner up, momentum. A risk-adjusted view displays more dichotomy between the two factors, as low volatility enjoyed a more-than 40% higher Sharpe Ratio than momentum during the entire three-month race, giving participants who chose some or all low volatility a bit easier of a Derby ride. A rocky experience for momentum can be expected, and ultimately it fell just shy of the champion spot despite the high number of bets from the field.

Exhibit 2: Low Volatility Hangs on to Win

The golden rule in life is to “treat others the way you want to be treated.” Investing’s golden rule is diversification, which Harry Markowitz called “the only free lunch in finance.” Yet plenty of participants, and even the three of us, chose one factor for their entire portfolio. While co-author Chris and I both followed the hot-dot with a 100% momentum portfolio, we had a contrarian ticket from the third member of the group, as Sam placed his whole basket in low volatility, which provided a better result.  The Factor Derby highlights the difficulty of timing factors – or any investment – in a short window. And, as a good reminder of how wrong consensus can be, low volatility was the most overlooked factor in the sprint, and ultimately won the prize.

Although not an option in the challenge, Oppenheimer Russell 1000 Dynamic Multifactor ETF (OMFL) outpaced all individual factors over the three months of the challenge. Some investors like the do-it-yourself approach, but for those who would prefer to leave the factor bets to the pros, a multi-factor fund can offer diversification among factors in an effort to smooth out the ride. Cyclicality aside, it is our opinion that these “horses” are part of a new, more precise breed of long-term investments that can help investors build more efficient portfolios.