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DRS vs. Low Volatility Strategies

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Strategy Comparison Series

One of the new strate­gies attract­ing atten­tion and assets these days is “low volatil­i­ty” invest­ing. Also described as “man­aged volatil­i­ty” or “min­i­mum volatil­i­ty,” these strate­gies are mar­ket­ed as a bet­ter mouse­trap in the world of invest­ing. With this post, we will ana­lyze whether or not these low volatil­i­ty strate­gies real­ly have any­thing new to offer. This fits into an ongo­ing series of posts where we answer the fol­low­ing ques­tions:

  1. What are the dri­vers of returns in each strat­e­gy?
  2. What are the risks in each strat­e­gy?
  3. What role does a giv­en strat­e­gy play with­in a port­fo­lio?
  4. How does the giv­en strat­e­gy com­pare to the Defined Risk Strat­e­gy?

Before dis­cussing the above top­ics, how­ev­er, it is nec­es­sary to define just what peo­ple mean when they use the term “low volatil­i­ty” invest­ing.

Low volatil­i­ty bet­ter describes an out­come or a goal rather than an invest­ment process; there are sev­er­al dif­fer­ent ways one can pro­duce low volatil­i­ty results. The prod­ucts called low volatil­i­ty or man­aged volatil­i­ty typ­i­cal­ly fol­low one of two dif­fer­ent invest­ment strate­gies.

 

Two Types of Low Volatility Investing

The first and more com­mon approach to low volatil­i­ty invest­ing is essen­tial­ly a form of fac­tor analy­sis. Using a quan­ti­ta­tive scor­ing sys­tem, a large pool of stocks is scored then ranked on either their his­toric or antic­i­pat­ed volatil­i­ties. A port­fo­lio is then assem­bled from the stocks that have favor­able, low volatil­i­ty rank­ings. For any­one famil­iar with the “smart beta” move­ment, this type of fac­tor analy­sis should sound quite sim­i­lar.

An alter­na­tive way to pro­duce low volatil­i­ty results is to sell out of the more volatile asset class­es before things go south. A strat­e­gy like this might poten­tial­ly invest in equi­ties, bonds, cash and attempt to pro­duce less volatile results by mov­ing from equi­ties to fixed income before a cor­rec­tion or bear mar­ket and then jump back in to equi­ties dur­ing bull mar­kets. Of course, some would call such a strat­e­gy tac­ti­cal asset allo­ca­tion or mar­ket-tim­ing, and they wouldn’t be too far from the truth.

 

Different Approaches, Same End

These are two very dif­fer­ent paths that attempt to get to the same end­point, i.e. a pat­tern of returns less volatile than that of a buy-and-hold, ful­ly invest­ed, cap-weight­ed index like the S&P 500. The for­mer approach of scor­ing indi­vid­ual stocks on their volatil­i­ty char­ac­ter­is­tics is more of a bot­tom-up strat­e­gy, where­as the lat­ter, tac­ti­cal asset allo­ca­tion approach can be described as top-down. When it comes to the returns, risks, and roles of low volatil­i­ty or min­i­mum volatil­i­ty, the two approach­es must be treat­ed dif­fer­ent­ly.

Low Volatility Approaches - Swan Blog - DRS vs Low Volatility

 

Drivers of Returns

If a low volatil­i­ty strat­e­gy is built from the bot­tom up by rank­ing indi­vid­ual stocks on their “volatil­i­ty scores,” then suc­cess or fail­ure will large­ly depend on whether or not that fac­tor hap­pens to be in favor. Smart beta, fac­tor analy­sis, strate­gic beta, what­ev­er you want to call it, is all the same thing. A sub­set of stocks from a large pool is iden­ti­fied to be more sen­si­tive to or dis­play cer­tain quan­tifi­able traits. The list of poten­tial traits is inex­haustible, but some of the more com­mon ones are val­ue, growth, div­i­dends, momen­tum, size, and, yes, volatil­i­ty. The prob­lem, how­ev­er, is that there is no one mag­ic fac­tor that always works. Every fac­tor will have peri­ods when it is work­ing and peri­ods when it does not.

For the top-down, mar­ket-tim­ing approach to volatil­i­ty man­age­ment, the dri­vers of returns will be at the asset class lev­el, and the keys to suc­cess is being in the right place at the right time. Cer­tain­ly if one has the where­with­al to 1) suc­cess­ful­ly fore­cast major mar­ket sell-offs and avoid them and 2) pre­dict when mar­kets are about to take off and cap­i­tal­ize on ral­lies, then their per­for­mance results would look fan­tas­tic.

 

Risks

As dis­cussed pre­vi­ous­ly, when it comes to fac­tor analy­sis, no fac­tor works all the time. The best a fac­tor-based approach can rea­son­ably hope for is to be right more often than it is wrong. The big­ger risk, how­ev­er, is that most fac­tor analy­sis does noth­ing to address the biggest “fac­tor” of all—market risk. A ful­ly invest­ed port­fo­lio that tilts toward low volatil­i­ty, or any oth­er fac­tor, is unlike­ly to avoid sig­nif­i­cant loss­es should the mar­kets sell off by 30%, 40%, 50% or more. This top­ic is explored in our blog post on smart beta strate­gies and sys­tem­at­ic risk.

For those low volatil­i­ty strate­gies that employ a top-down, mar­ket tim­ing approach, the risks are dif­fer­ent. As stat­ed before, the key to suc­cess with the mar­ket is being in the right place at the right time. The risks, how­ev­er, are being in the wrong place at the wrong time. If one “miss­es the boat” with their tac­ti­cal asset allo­ca­tion deci­sions, either absolute or rel­a­tive per­for­mance can suf­fer great­ly. Mar­ket-tim­ing is explored in depth in this blog post, but can be sum­ma­rized with the old catch­phrase, “Live by the sword, die by the sword.”

 

Role in a Portfolio

If either a bot­tom-up, fac­tor-dri­ven or top-down, mar­ket tim­ing low volatil­i­ty strat­e­gy is able to suc­cess­ful­ly gen­er­ate low­er over­all volatil­i­ty, then it would like­ly ben­e­fit an over­all port­fo­lio. In a pre­vi­ous blog, we dis­cussed the detri­men­tal impact volatil­i­ty drag or vari­ance drain can have on an investment’s return. Low volatil­i­ty is cer­tain­ly a desir­able trait in an invest­ment. In fact, the DRS also has “low volatil­i­ty” as a goal for its port­fo­lio, but we seek to accom­plish low volatil­i­ty in a dif­fer­ent fash­ion.

 

Low Volatility Strategies vs. Defined Risk Strategy

Where the DRS dif­fers from “low volatil­i­ty” or “man­aged volatil­i­ty” strate­gies are in phi­los­o­phy and approach. Swan believes that the biggest risk that any investor faces is mar­ket and sys­tem­at­ic risk. Dur­ing the big, bear mar­ket sell-offs, almost every­thing tends to go down at the same time. A fac­tor-based, bot­tom-up, low volatil­i­ty strat­e­gy might out­per­form the S&P 500 on a rel­a­tive basis, but it will like­ly still lose a sig­nif­i­cant amount in absolute terms. With respect to mar­ket-tim­ing, Swan has always been skep­ti­cal. Swan believes it is too dif­fi­cult to con­sis­tent­ly call the tops and bot­toms of mar­kets and repo­si­tion the port­fo­lio accord­ing­ly.

It is these two core beliefs—the con­cern regard­ing mar­ket risk and a lack of faith in market-timing—that under­pin our “always invest­ed, always hedged” phi­los­o­phy. Unlike the top-down, mar­ket-tim­ing strate­gies, we remain “always invest­ed” with our buy-and-hold posi­tions in mar­ket ETFs. While bot­tom-up, volatil­i­ty-fac­tor analy­sis fails to address sys­tem­at­ic risk, we seek to do so and remain “always hedged” by pro­tect­ing the port­fo­lio via long-term put options. Using this time-test­ed strat­e­gy, we believe we have a bet­ter way of pro­duc­ing low volatil­i­ty results.

 

About the Author:

Marc Odo, Marc Odo, CFA®, CAIA®, CIPM®, CFP®, Director of Investment Solutions - Swan Global InvestmentsMarc Odo, CFA®, CAIA®, CIPM®, CFP®, Direc­tor of Invest­ment Solu­tions, is respon­si­ble for help­ing clients and prospects gain a detailed under­stand­ing of Swan’s Defined Risk Strat­e­gy, includ­ing how it fits into an over­all invest­ment strat­e­gy. For­mer­ly, Marc was the Direc­tor of Research for 11 years at Zephyr Asso­ciates.

 

 

 

 

Impor­tant Notes and Dis­clo­sures:

Swan Glob­al Invest­ments, LLC is a SEC reg­is­tered Invest­ment Advi­sor that spe­cial­izes in man­ag­ing mon­ey using the pro­pri­etary Defined Risk Strat­e­gy (“DRS”). SEC reg­is­tra­tion does not denote any spe­cial train­ing or qual­i­fi­ca­tion con­ferred by the SEC. Swan offers and man­ages the DRS for investors includ­ing indi­vid­u­als, insti­tu­tions and oth­er invest­ment advi­sor firms. Any his­tor­i­cal num­bers, awards and recog­ni­tions pre­sent­ed are based on the per­for­mance of a (GIPS®) com­pos­ite, Swan’s DRS Select Com­pos­ite, which includes non-qual­i­fied dis­cre­tionary accounts invest­ed in since incep­tion, July 1997, and are net of fees and expens­es. Swan claims com­pli­ance with the Glob­al Invest­ment Per­for­mance Stan­dards (GIPS®).

All Swan prod­ucts uti­lize the Defined Risk Strat­e­gy (“DRS”), but may vary by asset class, reg­u­la­to­ry offer­ing type, etc. Accord­ing­ly, all Swan DRS prod­uct offer­ings will have dif­fer­ent per­for­mance results due to offer­ing dif­fer­ences and com­par­ing results among the Swan prod­ucts and com­pos­ites may be of lim­it­ed use. All data used here­in; includ­ing the sta­tis­ti­cal infor­ma­tion, ver­i­fi­ca­tion and per­for­mance reports are avail­able upon request. The S&P 500 Index is a mar­ket cap weight­ed index of 500 wide­ly held stocks often used as a proxy for the over­all U.S. equi­ty mar­ket. Index­es are unman­aged and have no fees or expens­es. An invest­ment can­not be made direct­ly in an index. Swan’s invest­ments may con­sist of secu­ri­ties which vary sig­nif­i­cant­ly from those in the bench­mark index­es list­ed above and per­for­mance cal­cu­la­tion meth­ods may not be entire­ly com­pa­ra­ble. Accord­ing­ly, com­par­ing results shown to those of such index­es may be of lim­it­ed use. The adviser’s depen­dence on its DRS process and judg­ments about the attrac­tive­ness, val­ue and poten­tial appre­ci­a­tion of par­tic­u­lar ETFs and options in which the advis­er invests or writes may prove to be incor­rect and may not pro­duce the desired results. There is no guar­an­tee any invest­ment or the DRS will meet its objec­tives. All invest­ments involve the risk of poten­tial invest­ment loss­es as well as the poten­tial for invest­ment gains. Pri­or per­for­mance is not a guar­an­tee of future results and there can be no assur­ance, and investors should not assume, that future per­for­mance will be com­pa­ra­ble to past per­for­mance. All invest­ment strate­gies have the poten­tial for prof­it or loss. Fur­ther infor­ma­tion is avail­able upon request by con­tact­ing the com­pa­ny direct­ly at 970–382-8901 or www.swanglobalinvestments.com068-SGI-020218

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By |2018-02-02T12:28:06+00:00February 2nd, 2018|Blog|Comments Off on DRS vs. Low Volatility Strategies