A Little Bit of Low Vol Can Go a Long Way

The fourth quarter of 2018 was pretty turbulent for global equities.  Volatility and correlations rose, the majority of the S&P Global BMI’s 48 country constituents declined by double digits, recent darlings among factor strategies (momentum and growth) lagged, and the S&P 500’s 13.52% quarterly plunge left the benchmark with its first calendar-year loss in a decade.  Navigating the heightened volatility environment was likely a priority for many market participants.

Exhibit 1: Most country constituents of the S&P Global BMI declined by double digits in Q4Source: S&P Dow Jones Indices’ “Daily Dashboard”.  Data as of Dec. 31, 2018.  Returns calculated in USD.  Past performance is no guarantee of future results.  Chart is provided for illustrative purposes only.

Perhaps unsurprisingly, more defensive equity strategies typically receive greater attention during periods of heightened volatility.  Against that backdrop, we review stylized examples of asset allocation strategies using the S&P 500, the S&P 500 Low Volatility Index, and the S&P U.S. Treasury Bond Index.

Exhibit 2 shows the impact of switching S&P 500/S&P U.S. Treasury Bond allocations from 70%/30% to 50%/50% each month, depending on whether the S&P 500’s subsequent monthly total return was positive or negative, respectively.  These allocations were chosen so that, on average over the entire period, the hypothetical asset allocation strategy allocated 60% to equities and 40% to bonds.  Armed with a prediction that correctly identified the directional movement in the S&P 500 over the next month with 52% accuracy, the hypothetical “asset allocation” strategy could have provided higher risk-adjusted returns than a hypothetical 60% equity and 40% fixed income allocation, rebalanced monthly.

Exhibit 2: Asset allocation offered higher risk-adjusted returns compared to a static portfolio.

Given there is no crystal ball that tells us whether the S&P 500 will rise or fall over the next month, an asset allocation strategy runs the risk of not obtaining the desired downside protection, or missing out on equity market gains, if predicted outcomes do not materialize.  One way to bypass this issue is to maintain static equity and fixed income allocations, and to incorporate equity factor strategies designed to mitigate downside risks.  Low volatility may be an appealing choice for many, given its historical propensity to marry downside protection and upside participation.

Exhibit 3 shows the cumulative total returns of a hypothetical “low vol equity” portfolio with static 30%/30%/40% allocations to the S&P 500/S&P 500 Low Volatility/S&P U.S. Treasury Bond Index, rebalanced monthly.  The hypothetical portfolio offered greater downside protection than either of the 60/40 or asset allocation strategies: on average, the low vol equity portfolio captured 44.8% of S&P 500 returns during months when the equity benchmark declined, compared to over 50% for the other hypothetical portfolios. This helped it to outperform on a risk-adjusted basis, historically.

Exhibit 3: The hypothetical “low vol equity” strategy outperformed on a risk-adjusted basis.

Of course, there are many ways that market participants may seek to navigate equity market turbulence and there are many different paths that returns could take when using an uncertain prediction.  But the above example shows how incorporating low volatility within a static equity allocation could act as an alternative to adjusting asset allocations.  Not only would such a strategy bypass the difficulty in correctly timing the market, but it could have improved upon the hypothetical performance of an asset allocation strategy, historically.

The posts on this blog are opinions, not advice. Please read our disclaimers.

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