Conservative Equities Are Poised For Significant Outperformance Over the Next Years

Introduction

Following the previous article about the low-vol anomaly, it might be interesting to dig deeper into the drawdown frequencies and the rolling 1-year out-or underperformance. As can be seen below, investing in the USMV tracker in 2012 (and then looking at the following 1-year performance) yielded no additional profits compared to the equal-weighted USA ETF. The same is true for new cash injections in 2015 when a rebound in risky assets occurred in late 2016.


All in all, one would have generated the same results yet the standard deviation in the rolling 1-year returns of the USMV tracker is substantially lower: 6.2% versus 10.1%.

(Source: Option Generator Research)


However, it's the drawdown graph which appeals us: minimum-volatility stocks tend to exhibit smaller drawdowns and post faster rebounds. This is especially visible in the first quarter of 2016 and the fourth quarter of 2018. On the contrary, the strategy didn't provide meaningful cushion in February 2018 and during the Covid-19 crash. The steeper the declines, the weaker the low-vol anomaly comes into play. As mentioned in the previous article, during strong up markets you can expect low-vol/min-vol strategies to underperform the market.

(Source: Option Generator Research)


However, 10+ % drawdowns tend to occur less frequently for min-vol stocks. This isn't about outpacing high-risk investments during rallies, it's about winning by not losing or losing less. Please note that on a daily basis, it's difficult to always hit new all-time highs.

(Source: Option Generator Research)


The evolution of the new highs in both the USMV and EUSA tracker is quite informative. In early 2016, the USMV tracker set plentiful all-time highs in a row while the equal-weighted USA ETF faced more turbulence before bucking the trend after the US elections. The same picture now shows up and in our opinion it highlights one element: investors are fully targeting higher-beta, beaten down stocks. Quite remarkable, over the past 9 years there's been a 0.7% probability of losing with min-vol investments in a rising stock market environment. 52% of the time, though, the 1-year returns have exceeded those of the equal-weighted USA tracker.

(Source: Option Generator Research)


There's a good chance the next two/three years will be great for min-vol strategies. Interest rates remain low, defensive investors are yield-starving, the wall of worries (high debt burdens, COVID-19 impact on the old economy) still exists. On a two year time frame, the smoothed 1-year rolling returns can oftentimes show diverging patterns. Following the 2016 divergence, min-vol strategies kept up with the benchmark before showing extreme resilience in 2018. That's a scenario which hasn't been sufficiently priced in yet by the market.

(Source: Option Generator Research)

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