Since antiquity, people have measured time in months. Unsurprisingly, investors tend to evaluate performance in monthly increments. This can be troublesome, as we will see in the case of low volatility, particularly during market regime changes.
Low volatility strategies are designed to provide investors with protection in falling markets and participation in rising markets. Disappointments can occur in two ways:
- The strategy underperforms falling markets
- The strategy falls during rising markets
Success rates for the S&P 500® Low Volatility Index approximate 85% on both of these dimensions.
The first quarter of 2018 was unusual, as the market initially underwent an expansive phase, during which cyclical sectors outperformed, up until the market peak on Jan. 26, 2018. Subsequent to this peak, the market began to decline when defensive sectors eventually outperformed.
How was low volatility affected by this regime shift? Let us start with January, when the U.S. market was off to a booming start, with the S&P 500 up 5.73%, while the S&P 500 Low Volatility Index lagged, only up 2.65%. This outcome is expected: Underperformance in a rising market is not a failure, but one of the inherent features of low volatility strategies.
In February, low volatility underperformed the market, with the S&P 500 Low Volatility Index down 4.24%, while the S&P 500 was down 3.69%. This outcome is unexpected: Underperformance in a falling market is a failure of protection, one of the key benefits of low volatility strategies.
But before we can declare failure, we need to understand better what happened in February.
An underweight to information technology, which was the best-performing sector in February, was the main driver of low volatility’s February underperformance, along with an overweight to utilities and real estate. These three sector tilts together cost the strategy 1.05% (in a month when it underperformed by only 0.55%).
But low volatility did indeed subsequently deliver protection. March’s performance was a complete reversal from February’s—low volatility now handily beat the market, with the S&P 500 Low Volatility Index up 0.85%, compared to the S&P 500’s bleak performance, down 2.54%. Overweights to utilities, real estate, and financials, along with an underweight to information technology, contributed 2.85% to the strategy’s outperformance. These are the very same sector tilts that detracted from February’s performance.
The outperformance in March required enduring some underperformance in February. This illustrates a broader, more important principle: Evaluating any factor strategy over a period as short as one quarter requires paying careful attention to the nature of the investment environment.