We all know that in the long run, the U.S. stock market has performed very well, compounding at well over 10% per year for nearly a century. We also know that sometimes the market performs very poorly, as the S&P 500®’s 20% decline in the first half of 2022 reminds us. For an investor who has the luxury of time, the combination of long-term gains with occasional pullbacks is a feature, not a bug; short-term declines are at worst a nuisance, and at best a buying opportunity.
For some investors, however, time is a luxury they do not have. Individuals often have specific goals to which finite time horizons attach. Such investors can benefit from the equity market’s long-term strength, but may have above-average sensitivity to short-term declines.
Defensive factor indices can help resolve this tension. Factor indices in general are designed to indicize active strategies—i.e., to deliver in passive form a pattern of returns that the investor would otherwise have to pay active fees to obtain. Exhibit 1 shows the relative risk and return of several S&P 500-based factor indices. Given the risk/return profiles in the exhibit, we can classify factor indices as either risk enhancers or risk mitigators—mitigators to the left, enhancers to the right.
We think of Low Volatility as the quintessential risk mitigator. Exhibit 2 shows why, comparing two efficient frontiers, one constructed using the S&P 500 and bonds, and the other using the S&P 500 Low Volatility Index and bonds.
For the period summarized in Exhibits 1 and 2, Low Volatility outperformed the S&P 500, but with lower risk. It’s therefore not surprising that an efficient frontier using Low Volatility as the risky asset dominates a frontier using the S&P 500. A 60/40 equity/bond allocation using Low Volatility experienced both lower risk and higher return than a 60/40 mix using the S&P 500.
Importantly, time-sensitive investors could use Low Volatility to improve their risk/return tradeoff. A 60/40 mix of the S&P 500 and bonds produced a total return of 8.3%, with a standard deviation of 8.8%. By using Low Volatility as the equity vehicle, the same return could have been achieved at a lower risk level (6.9%) and with a lower equity exposure (55%). Alternatively, using Low Volatility as the equity vehicle would have increased returns to 9.3% with the same risk level. Indeed, regardless of the starting point, shifting any part of an equity allocation from the S&P 500 to the S&P 500 Low Volatility Index would have resulted in both a reduction in overall risk and an increase in return.
What is true of Low Volatility is also true of other defensive factors. Time-sensitive investors should consider the record of defensive factor indices in mitigating short-term declines while retaining the long-run benefits of equity exposure.The posts on this blog are opinions, not advice. Please read our Disclaimers.