If You Can't Tame Volatility, Can You At Least Time It?

Before we kick off this week’s issue, we encourage you to check out Newfound Research’s Flirting with Models podcast which recently featured Omega Point’s Omer Cedar in which he discusses: how quantitative investors have impacted markets, how fundamental managers should think about factors, the low-hanging fruit for optimization, and surprising lessons he has learned in evaluating fundamental portfolios. We hope that you find it enjoyable and thought provoking.

Now on to this week’s topic. Just like orange is the new black, high volatility might be the new steady eddy safe haven for investors. Before we get to that, let’s recap what happened since our last article in the Volatility series.

We last left off with the Volatility factor continuing its unusual bull run and peaking on August 28 with a YTD return of 6.73%. Since then, Volatility has dipped over 100 bps to a YTD return of 5.52%, as the market has been thrown into rocky territory with a major sell-off over the past few days that’s erased almost all gains from August.

General volatility is top of mind for most investors, with the VIX up over 25% on Sept 3 sliding into the Labor Day weekend and currently hovers well above its entire August values. With this in mind, we return to our analysis into Volatility’s post-COVID behavior and conclude our series with some thoughts on the broader implications of a reversal of this factor.

Especially given the last few days of the stock market roller coaster ride, it’s worthwhile to not only understand why the Volatility factor is rallying, but also to think through the impact on strategies that are built on the assumption that this factor is always a bad bet. In particular, the minimum volatility investing phenomena - which saw over $100 billion of assets flow into low and minimum volatility ETFs by the end of 2019 - is likely to be thrown for a loop if Volatility decides to change course.

Low Volatility Takes a Nosedive

Typically, the minimum volatility phenomena is driven by stocks with low Volatility exposure outperforming, not by high Volatility stocks underperforming. In other words, the strategy is to invest in low Volatility names rather than to short high Volatility names. To see this historically, we can dissect our high-minus-low (HML) Volatility portfolio from our past analyses into two long-only sub portfolios to represent high and low exposure to the factor.

Looking at the performance of these two portfolios from 2007 - 2019, we see that both have positive performance. The low Volatility portfolio (purple) returns over 450% (14% annualized) while the high Volatility portfolio (blue) returns only 25% (1.7% annualized) over the period.

If we’d invested in either portfolio in 2007, we would have made money over the 12-year timeframe. However, we would have made orders of magnitude more if we’d invested in the low Volatility portfolio - and herein lies the impetus for the low volatility investing phenomena.

Now, if we look at the 2020 YTD performance of these same portfolios, we see a wildly different trend.

On a YTD basis, the high Volatility portfolio (blue) returns over 10% while the low Volatility portfolio (purple) has a negative return of almost -22%! Not only is this a complete reversal to what we saw in the 2007-2019 period, but we would have lost a lot of money if we’d invested in the low Volatility portfolio at the beginning of 2020.

If the minimum volatility phenomena were forming for the first time today, the strategy very well could be to go short rather than long low Volatility.

Although high Volatility stocks are doing well on a YTD basis, the real story here is that the Volatility reversal is largely driven by low Volatility stocks underperforming. This points to a potential breakdown in the foundation for low volatility investing.

Is Volatility the New Bargain Sale?

One possible explanation for the reversal of high vs low Volatility is in how the market is speculating on cheap vs expensive names. Looking at the Value factor exposure within our high and low Volatility portfolios supports this theory. The Value factor represents the book-to-price ratio, so increasing Value indicates the portfolio is becoming cheaper while decreasing Value points to the portfolio becoming more expensive.

In overlaying the Value factor on our high Volatility portfolio, we see that this portfolio has generally been getting cheaper since the beginning of 2020. The portfolio started the YTD period with Value exposure around 0.55, and despite a downward jump in July, the portfolio is currently sitting at an exposure of 0.7.

Turning to the low Volatility portfolio, this portfolio is generally more expensive, peaking at a Value exposure of 0.64 during the March market downturn and declining significantly to a current level of 0.

With high Volatility becoming cheaper and low Volatility becoming more expensive, investors are likely flocking to these high Volatility names that look more attractive than ever, especially in contrast to the low Volatility names.

‍Given the market sell-off over the past week, it’s very possible we’re in the midst of yet another Volatility reversal and the factor rally was driven by the perfect storm of 2020 rather than a change in the fundamental behavior of the factor. It’s impossible to say where Volatility will go from here, but as the past several weeks of analysis have shown, we can’t take our eye off the Volatility ball for too long, or we may find ourselves swept up by Volatility’s unpredictable new normal.

US & Global Market Summary

US Market: 8/31/20 - 9/11/20

• The market endured some fits of volatility over the past two weeks, with the three major indices ending the holiday-shortened week sharply lower (S&P 500 was down 2.5% this past week).
• The NASDAQ was particularly affected, seeing its largest weekly loss since March 20th as tech stocks sold off.
• Uncertainty abounds for investors between COVID rates and timeline of vaccine availability, precarious US - China relations, and the upcoming US elections.
• The market is also waiting for more clarity from the Fed on Wednesday about how it will actually implement its new average inflation targeting framework.

Normalized Factor Returns: Axioma US Equity Risk Model (AXUS4-MH)

• Earnings Yield was the biggest winner over the past two weeks, climbing from -0.25 standard deviations below the mean into positive territory.
• Size also saw some normalized gains as larger cap stocks came back into favor.
• Market Sensitivity entered positive territory after seeing positive normalized gains for the 9th consecutive week.
• Volatility - our topic du jour, continued to see slight strength on a normalized basis.
• Growth continued to fall deeper towards an Extremely Oversold label, falling by over half a standard deviation in the past two weeks.
• Momentum bore the brunt of the market’s reversal, free falling by 1.22 standard deviations and now sitting at -0.43 SD below the mean.
• US Total Risk (using the Russell 3000 as proxy) has been on the rise, hitting a recent peak of 25.68% on 9/8 and now still sitting at 22bps higher than on 8/31.

Normalized Factor Returns: Axioma Worldwide Equity Risk Model (AXWW4-MH)

• The rally in Size continued for the third week, as it continued to climb towards positive territory.
• ‍Market Sensitivity enjoyed ongoing strength, and looks poised to exit negative space soon if the trend holds.
• ‍Volatility saw some positive movement as it distanced itself from its former Oversold label.
• ‍Value experienced a slight decline, crossing into Oversold space.
• ‍Growth tumbled further into Oversold territory, now sitting at -1.54 SD below the mean.
• The reversal in Profitability continued, as it shed its Overbought designation as it fell by over half a standard deviation.
• Just as we saw in the US, Momentum was the week’s biggest loser as it plummeted by -1.55 standard deviations, and heads towards Oversold territory. As a reminder, this factor was at +2.58 SD on 8/5.
• Unlike the US, Global Risk (using the ACWI as proxy) declined by 37bps.

Regards,
Alyx