Low Vol Strategies Crushed In May

Low volatility had a bad month in May, and there has been a slew of commentary on this - see Abnormal Returns for a bunch of links.

Deutsche Bank's 'The Quant View' by Rochester Cahan summarized the month's performance by noting that "Last month we argued that the Low Volatility/High Dividend Yield trade was looking crowded, and cautioned that this could indicate elevated downside risk. It turns out that call was prescient."

"Could" and "change in probability" means nothing, because it's consistent with anything, eg, if the rate rises it's hardly testable because the old and new probability are couched merely as possibilities, and if the probability doesn't change, that's in the forecast too ('could'). Now if they said, don't buy or short strategy X this month, that would have been prescient. I wonder if such people realize how disingenuous this is, or if they think their nuance is actually highly rigorous analysis.

In any case, last month was very bad for low volatility strategies, leading many researchers to reassess the validity of this approach. But, to put it in perspective, here's the total return over the past 12 months, using my beta data.


Clearly the past year, higher beta has been the better place to be, while lower beta has not. As the SP500 rose 26% from May 31 2012 through May 31 2013, this is not surprising: on average, over shorter horizons like years, betas are accurate, so higher beta stocks do better in rising markets, lower beta portfolios underperform. For example, over the past year, given the SP500 rose 26%, low beta stocks rose 70% of that, high beta 170% of that, implying betas of 0.7 and 1.7, which is totally consistent with the simple CAPM for the high beta stocks, and better-than-expected for the low beta portfolio (ie, its beta was 0.6 in that period). If you bought low vol stocks not understanding this, well, you really need to.

Now, many people seem to infer from this that low vol/beta has been a bad bet over the past year. If you evaluate yourself purely against the indices, this is true: deviations from the benchmark are only good if they are above the benchmark. Yet, in simple Sharpe ratio or Information ratio, high beta portfolio did poorly, even in this period. The clear winner is actually a Beta-1.0 portfolio, which has the highest Sharpe and Information ratio. Like low volatility, I have championed the beta 1.0 portfolio for a while, and I'm sure it will be a big fund someday.

Stats on US portfolios, 5/31/12-5/31/13

Internationally we see the same thing: low vol did worse in raw returns, but much better in a pure Sharpe.

See data here. I think this highlights a profound truth, that as a practical matter investors don't care about Sharpe ratios as much as returns relative to the benchmark.