Gen. Patton said if everyone’s thinking alike then somebody isn’t thinking. Investors who pile into “can’t miss” strategies at the most inopportune times know this all too well. The latest craze is Low Volatility single-factor strategies.
While we are thrilled that investors are catching onto Smart Beta, and believe single-factor strategies like Low Volatility can be great tools to control a portfolio’s risk and return, sometimes the herd gets the timing wrong. For this specific strategy, we think the short term (6-18 months) may be one of those times. Let’s not forget how popular currency hedging became in 2015, only after the dollar rally stabilized, muting the strategy’s effects and providing limited benefit to investors.
Over the past year, investors have moved over $22 billion into Low Volatility strategies in the hopes of participating fully in rising markets while gaining some protection from the inevitable drawdowns. Unfortunately, as more investors pour into these strategies, the strategies may be losing the very characteristics investors crave.
Surprisingly, this past year’s incredible performance for the Low Volatility strategy was more exposed to Momentum (.33) and Low ROE (-.49) factors than the Low Volatility (-.27) factor. Exhibit 1.
The three main drivers of Low Volatility returns this past year have been:
- Valuation: Low beta, defensive stocks typically trade at valuations below that of the broader market. Today, defensive sectors like utilities, industrials and consumer staples are some of the most expensive sectors in the S&P 500 due to their bond-like yields. In fact, because of flows and the macro environment, the Low Volatility strategy is more overvalued to its historical average on a price to share basis than the S&P 500 Index. A majority of the returns have been from flow-induced price inflation, causing high valuations. The rapid expansion of price per share in the low beta market subset without an equal expansion of economic benefit is a classic example of “nonstructural alpha.” This type of alpha always reverts to the mean. It’s only the timing that is uncertain.
- Momentum: Momentum often reverts to the mean or said more simply, what goes up, eventually goes down. Run ups can happen in any sector, not just hot ones like technology, as investors tend to herd into yesterday’s winners. Buying into an overvalued defensive sector for the promise of yield has been this past year’s Momentum play. Those sectors also happen to be large overweights in Low Volatility, creating a second layer of flows at this level and adding a momentum push to the strategy’s factor profile.
- Low ROE: Defensive companies that have been eagerly bought up by investors have not been providing traditional shareholder value in terms of growth, measured by Return on Equity (ROE). Intuitively, companies that have high growth prospects deserve high valuations, yet the exact opposite is happening. It seems the only goal for Low ROE firms in this low rate world has been to deliver a stable dividend, making them more attractive than a multiyear bond, and almost guaranteeing attention from investors. At the company level, irrationally valued, Low ROE names have added to the Low Volatility strategy’s returns in an atypical way.
What’s an investor to do? Smart beta strategies now give investors the opportunity to harness certain factors like Momentum and Low Volatility. But investors attempting to use single-factor strategies may find themselves getting the timing wrong.
We designed our Revenue Weighted strategies to systematically gain exposure to the factors that drive performance. Unlike traditional single-factor exposures, our quarterly rebalance enables us to shift away from those companies whose market capitalization is climbing faster than the overall market, towards those companies whose revenues are bigger than other companies in the market. This allows us to participate in Momentum markets but to systematically pair back on Momentum so that we aren’t there when the bubble bursts. For example, our Large Cap Revenue portfolio is currently underweight the utilities sector and is trading at a price to sales ratio that is half that of the Low Volatility strategies. We believe price to sales is as good a predictor of future returns as any other valuation metric.
Here’s our best advice for investors in Low Volatility strategies: Smooth the portfolio by adding a Revenue Weighted strategy in a 50/50 mix. That has the potential to reduce your exposure to Momentum, balance out defensive sector overweights and deliver other portfolio benefits as well:
- Absolute Performance1: Adding a Revenue Weighted strategy has the potential to increase standard deviation and improve upside performance.
- Information Ratio2: Revenue Weighted strategies have the potential to increase a portfolio’s information ratio, which tends to increase the portfolio’s ability to make accurate bets.
- Tracking Error3: Most managers have mandates on fit (style, size) when they attempt to replace the standard market-cap weighted S&P 500 index. The Revenue Weighted Strategy’s R2 and tracking error relative to Market Cap make it a more appropriate substitute than Low Volatility.
- Sharpe Ratio During Rising 10 Year Rates4: Rising rates are the bane of bond funds and bond like equities. Low Volatility Strategies tend to lose their luster when the economy improves. Revenue Weighted strategies outperform Low Volatility on a risk adjusted basis when the macro regime shifts in this direction.
So be wary of strategies that may not act as advertised. Adhering to the herd mentality often proves to be a fool’s errand.
Follow @OppFunds for more news and commentary.
1 The return of an index measured from one period to another
2 The ratio of portfolio returns above the returns of a benchmark to the volatility of those returns
3 The difference between a portfolio’s returns and the benchmark or index it was meant to mimic or beat
4 A measure that indicates the average return minus the risk-free return divided by the standard deviation of return on an investment
An investment in the Fund is subject to investment risk, including the possible loss of principal amount invested. Fund returns may not match the return of its respective index, known as non-correlation risk, due to operating expenses incurred by the Fund. The alternate weighting approach employed by the Fund (i.e., using revenues as a weighting measure), while designed to enhance potential returns, may not produce the desired results. Because the Fund is rebalanced quarterly, portfolio turnover may exceed 100%. The greater the portfolio turnover, the greater the transaction costs, which could have an adverse effect on Fund performance.
These views represent the opinions of OppenheimerFunds, Inc. and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of the publication date, and are subject to change based on subsequent developments.