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Not Your Father’s Low Volatility Strategy

By Fei Mei Chan Low volatility strategies were a popular and growing category in 2015, and if the first several days of 2016 are any indication, it wouldn’t be surprising to see their popularity continue in the New Year. That said, the topic of low volatility investing often comes with much discourse. A frequent argument is that a low volatility tilt is very similar, if not synonymous, to a bet on a small number of sectors or industries. In its 25-year history, the S&P 500 Low Volatility Index has often had high concentration in low volatile sectors – most frequently Utilities, Financials, and Consumer Staples. The index seeks out the least volatile stocks – with no sector constraints – so having large positions in sectors with relatively lower risk is not surprising. However, there’s more to the low volatility story than a sector bet . As an exercise, we produce a hypothetical low volatility portfolio whose sector weights match those of the S&P 500 Low Volatility Index but whose sector returns match those of the complete S&P 500. The hypothetical results tell us to what extent Low Vol’s results come from sector tilts alone, vs. stock selection within sectors. As shown below, over the last 25 years, the hypothetical portfolio’s standard deviation was between those of the S&P 500 and the S&P 500 Low Volatility Index. Being in the Low Vol’s sectors during this period accounted for more than two-thirds of the total volatility reduction achieved by the S&P 500 Low Volatility Index. In the same period, the return increment attributed to being in the “correct” sector was only 24%. More than three-quarters of Low Vol’s outperformance is idiosyncratic to its stock selection methodology. We’re not alone in arguing for the existence of the low volatility effect independent of sector impacts. Baker, Bradley, and Taliaferro , in decomposing the low risk anomaly, found that stock selection contributed to higher alpha, while the contribution from industry selection was negligible. Asness, Frazzini and Pedersen concluded that even holding the industry effect neutral, low volatility bets exhibited positive returns. The implication of all this research is that a sector tilt can’t account for all the performance differentials of low volatility. To assume that the two strategies are synonymous is to leave something on the table. Disclosure: © S&P Dow Jones Indices LLC 2015. Indexology® is a trademark of S&P Dow Jones Indices LLC (SPDJI). S&P® is a trademark of Standard & Poor’s Financial Services LLC and Dow Jones® is a trademark of Dow Jones Trademark Holdings LLC, and those marks have been licensed to S&P DJI. This material is reproduced with the prior written consent of S&P DJI. For more information on S&P DJI and to see our full disclaimer, visit www.spdji.com/terms-of-use .

Broadleaf Partners Fourth-Quarter 2015 Commentary And Performance Review

Our portfolio and the stock market bounced back aggressively in the fourth quarter, following the Chinese yuan-induced swoon during the third quarter. We finished the full year in positive territory, substantially ahead of our comparative indices and peer group. While there has been much gnashing of teeth over the narrowness of the market’s gains this year, and in particular the contribution of the FANG stocks (Facebook (NASDAQ: FB ), Amazon (NASDAQ: AMZN ), Netflix (NASDAQ: NFLX ) and Google ( GOOG , GOOGL ), we refuse to apologize for actually having the gall to own these names in 2015 and, for some, far earlier. It’s always easy to see what worked in the rear-view mirror, but far harder to discern what’s ahead. Remember this next time someone gives you excuses or even worse, makes you feel like an apology is due for actually winning. Let’s be clear. We are not afraid to part ways with our long-term winners when we think the time is right; we’ve done that repeatedly in the past, and will do it in the future. A strong selling discipline is key to our investment process, and has been instrumental in driving our superior long-term results. My business partner, Bill Hoover, likes to say that buying stocks is easy; knowing when to sell is much harder. I agree. For further information on the fourth quarter and our investment outlook, please see this review: Broadleaf Q42015

Indexing Pioneer Vanguard Skeptical Of Smart Beta

Vanguard revolutionized investing with its low-cost, passive indexing products. But after the TMT (tech, media, and telecom) blowup of 2000-2002, when cap-weighted indexes became overstuffed with overvalued dot-coms, critics began maligning cap-weighted index funds as “dumb beta.” The alternative, in their view, was to weight stocks according to factors other than market cap – so-called “smart beta.” Smart-beta strategies have been hailed as the “new paradigm” in passive, index-based investing. But Vanguard, the indexing pioneer, disagrees: The firm’s Don Bennyhoff, Fran Kinniry, Todd Schlanger, and Paul Chin – authors of an August 2015 white paper titled ” An Evaluation of smart beta and other rules-based active strategies ” – insist that smart-beta strategies are in fact active strategies, and that market cap is still the best basis to weight the components of an index. How Active is Smart Beta? In Vanguard’s view, smart-beta strategies should be considered “rules-based active strategies,” by definition , since their security-selection and -weighting methodologies can produce “meaningful security-level deviations” – i.e., “tracking error” – versus a broad cap-weighted index. In the August 2015 white paper, Mr. Bennyhoff and his co-authors looked at the “active share” of smart beta ETFs and index funds. “Active share” is a measure of how much an index’s holdings deviate from a cap-weighted baseline, which in this case was the Russell 3000 – an index of the 3000 largest U.S. stocks, including the mid-to large-cap Russell 1000 and the small-cap Russell 2000: Source: Vanguard. All data as of December 31, 2014. In general, the more stocks in the index or portfolio, the less the “active share.” Smart-beta ETFs and funds had “active share” that ranged from a bit less than 30% to roughly 60%, generally much more than cap-weighted indexes, but less than “traditional, actively managed equity funds.” Smart-beta strategies also had less “active share” than ETFs focused on specific risk factors like value, momentum, and size – and its exposure to these factors that provides much of smart beta’s appeal, in Vanguard’s analysis. Which Factors and When? Vanguard admits that the performance of alternatively weighted indexes has been “compelling” over time. For instance, the alternative FTSE RAFI Developed Index returned an annualized 7.2% from 2000 through 2014, with a Sharpe ratio of 0.42. The cap-weighted FTSE Developed Index, by contrast, returned just 4.2% per year with a Sharpe ratio of 0.26. This relationship holds for most regions, too. But particular risk factors fall into and out of favor, and as a result, the performance of smart-beta strategies – relative to the broad market – has deviated substantially over time. Should investors only concern themselves with certain factors, such as dividends, cash flow, book value, sales, and volatility? Or should they consider all factors, which are too numerous to list? Vanguard says market cap-weighting captures all of these factors through the market-pricing mechanism – a compelling argument. Taking the Gloves Off Near the end of the white paper, Bennyhoff et al. take off their gloves: Smart beta doesn’t represent a “new paradigm” of indexing nor a “smarter” way to invest. The strategies’ excess returns can partly – in some cases largely – be attributed to “time-varying factor exposures,” which make smart-beta strategies effectively active and not passive. “We found little evidence that such smart-beta strategies have been able to capture any security-level mispricings in a systematic and meaningful way,” the authors wrote. An index of securities is supposed to represent “the risk-and-reward attributes of a market” or segment thereof. In Vanguard’s view, market-cap-weighting isn’t broken, and therefore isn’t in need of fixing. For more information, download a pdf copy of the white paper . Jason Seagraves contributed to this article.