Tag Archives: first-look

Low Volatility And Momentum: Doubling The Market Return

Summary This series offers an expansive look at the Low Volatility Anomaly, or why lower risk stocks have historically produced stronger risk-adjusted returns than higher risk stocks or the broader market. While low volatility strategies are often an appropriate long-term buy-and-hold strategy, this article offers a strategy that uses a momentum signal to tilt towards higher-beta securities selectively. The alpha-generative strategy combines two market anomalies – Low Volatility and Momentum – to produce outsized returns. In recent articles, I have been authoring a fairly extensive examination of the Low Volatility Anomaly, the tendency for low volatility assets to outpeform high beta assets over long-time intervals. A Low Volatility strategy was one of five buy-and-hold factor tilts that I described in a previous series of articles. I believe that these buy-and-hold strategies to capture structural alpha are appropriate for many in the Seeking Alpha audience, but understand that some readers are looking for strategies that can generate even higher absolute returns. This article depicts one such strategy. Long-time readers know that two of favorite topics on which to author have been Low Volatility and Momentum strategies. This article combines these two strategies to produce a return profile that as the title of the article suggests has more than doubled the return of the S&P 500 over the past quarter-century. Before we delve into this strategy, we should first discuss the two components that drive this tremendous performance. Low Volatility Anomaly Regular readers know that I am currently authoring a multi-part series on the Low Volatility Anomaly. These articles include an introduction to the concept, a theoretical underpinning for the anomaly , cognitive and market structure factors that contribute to its long-run performance, and empirical evidence that demonstrates the outperformance of low volatility strategies across markets, geographies and long time intervals. In past articles, I have depicted the relative outperformance of Low Volatility strategies using the graph below which shows the cumulative total return profile (including reinvested dividends) of the S&P 500 (NYSEARCA: SPY ), the S&P 500 Low Volatility Index (NYSEARCA: SPLV ), and the S&P 500 High Beta Index (NYSEARCA: SPHB ) over the past twenty five years. The volatility-tilted indices are comprised of the one-hundred lowest (highest) volatility constituents of the S&P 500 based on daily price variability over the trailing one year, rebalanced quarterly, and weighted by inverse (direct) volatility. Source: Standard and Poor’s; Bloomberg The Low Volatility strategy contributes an important base component to this strategy that would have doubled the return of the market over the past twenty-five years, but we also need an element that pushes the strategy into riskier parts of the market when we can get paid for this tilt in the form of higher returns. Momentum Like the low volatility strategy, momentum strategies have been alpha-generative over long time intervals and across markets. Consistent with Jegadeesh and Titman (1993), which documented momentum in stock prices that have outperformed in the recent past over short forward intervals, the efficacy of momentum strategies have been widely documented. Academic literature has described excess returns generated by momentum strategies in foreign stocks ( Fama and French 2011 ), multiple asset classes ( Schleifer and Summers 1990 ), commodities ( Gorton, Hayashi and Rouwenhorst 2008 ), and my own studies on momentum in fixed income strategies and more recently the oil market . Academic literature offers competing theories on why momentum has generated alpha over long time intervals across markets and geographies. Proponents of market efficiency suggest that momentum is a unique risk premium, and the long-run profitability of these strategies is compensation for this unique systematic risk factor ( Carhart 1997 ). Behaviorists offer multiple competing explanations. In my previous series, I referenced both Lottery Preferences and Overconfidence as potential justifications. Studies contend that markets under-react to new information ( Hong and Stein 1999 ), which allows for the autocorrelations found in return series. Other behavioral economists contend that the disposition effect, or the tendency for investors to pocket gains and avoid losses, makes investors prone to sell winners early and hold onto losers too long ( Frazzini 2006 ), which could be further amplified by a “bandwagon effect” that leads investors to favor stocks with recent outperformance. Blitz, Falkenstein and Van Vliet (2013) offer an expansive summary of these explanations. The Strategy I am of the opinion that low volatility stocks should be a part of investors’ longer-term strategic asset allocation given that class of stocks’ historical higher average returns and lower variability of returns. In ” Making Buffett’s Alpha Your Own ,” I described academic research ( Frazzini, Kabiller, Pederson 2013 ) that broke down the Oracle of Omaha’s tremendous track record at Berkshire Hathaway ( BRK.A , BRK.B ) into two components – capturing the Low Volatility Anomaly and the application of leverage. If an allocation to low volatility stocks should be part of your long-term strategic asset allocation, then an allocation to high beta stocks must be done tactically with a short-term focus given that class of stocks’ lower long-run average returns and higher variability of returns. This view is borne out of the data underpinning the chart above. However, a temporary allocation to the High Beta Index in sharply rising markets can further boost performance. The High Beta stock index has typically outperformed in post-recession recoveries. How do we combine Low Volatility and Momentum? A quarterly switching strategy between the Low Volatility Index and the High Beta Index, which buys the leg that has outperformed over the trailing quarter and holds that leg forward for the subsequent quarter, would have produced the return profile seen below since 1990, easily besting the S&P 500 with lower return volatility. For a pictorial demonstration of the leg that would be chosen by the Momentum strategy, please see the exhibit at the end of the article. It is a very simple heuristic. The Momentum strategy buys either Low Vol or High Beta stocks based on the index that outperformed in the trailing quarter and holds that index for the subsequent quarter before re-examining the allocation once again. The results are striking. (click to enlarge) From the cumulative return graph above, one can see that $1 invested in the S&P 500 would have produced $9.04 at the end of the period (including reinvested dividends) whereas $1 invested in the Momentum portfolio would have produced $19.90. These are gross index returns and do not consider taxes. Readers envisioning employing momentum strategies should utilize tax-deferred accounts. Summary statistics of the trade are captured below: (click to enlarge) The simple quarterly switching momentum strategy would have produced a 13% return per annum over the long sample period. This 3.6% outperformance relative to the S&P 500 led to the cumulative doubling of the market returns over time. Note that while the Momentum strategy is riskier than the broad market as measured by the variability of quarterly returns, practitioners of this strategy would have been rewarded with correspondingly higher returns for this incremental risk. While I contend that a long-run, buy-and-hold tilt towards lower volatility equity is probably appropriate for many Seeking Alpha readers, this article demonstrates a momentum-based switching strategy that can help inform investors when to pivot towards higher beta stocks when they offer returns commensurate with their higher risk. Disclaimer My articles may contain statements and projections that are forward-looking in nature, and therefore inherently subject to numerous risks, uncertainties and assumptions. While my articles focus on generating long-term risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance, and investment horizon. Exhibit: Returns of Low Vol, High Beta, Momentum, & Market (click to enlarge) Disclosure: I am/we are long SPLV, SPHB. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

5 Things I Learned From Jeff Bezos On Business And Investing

It was 18 years ago that Amazon (NASDAQ: AMZN ), the world’s largest bookseller and one of the most successful Internet companies, got listed. The company’s IPO was unique for two reasons. One, that was a period before the dawn of Internet businesses, and thus, most investors and brick-and-mortar competitors were convinced the company was a joke – an “Internet bookseller” with “no barriers to entry”. Michael Porter’s framework said it would go bust quickly. Then, Amazon’s founder and CEO Jeff Bezos was extremely frank with shareholders from the word go, which is truly unique in this world, where CEOs hide more than they reveal. So, in 1997, after the IPO, Bezos wrote an honest letter to shareholders in which he explained Amazon’s philosophy, which was (and is) quite different from the philosophies of most public companies. Why different ? Because, unlike other public companies that were (and are) obsessed with meeting and beating short-term shareholder demands, Bezos’s game plan was (and is) focused on long-term investments and value creation. And boy, see how well that strategy has paid off for shareholders who have kept their trust in Bezos’s game plan… (click to enlarge) US$ 100 invested in Amazon in its 1997 IPO is now US$ 31,036 – a 310-bagger, or a CAGR of 37.5%. That’s huge by any standards, but something just a tiny number of investors – mostly Amazon insiders – must have earned. Most others would’ve left the ship after earning a 5-, 10-, or 20-bagger. Anyway, there are many invaluable lessons I’ve learned from Bezos over the years, but these five stand out and have helped me immensely in my roles as an entrepreneur and investor. I’m sure these will benefit you too. So let me start right here. 5 Things I Learned from Jeff Bezos on Business and Investing 1) Think Really Long Term This is what Bezos said in an interview in 2011 (emphasis mine) … If everything you do needs to work on a three-year time horizon, then you’re competing against a lot of people. But if you’re willing to invest on a seven-year time horizon, you’re now competing against a fraction of those people, because very few companies are willing to do that. Just by lengthening the time horizon, you can engage in endeavors that you could never otherwise pursue. At Amazon we like things to work in five to seven years. We’re willing to plant seeds, let them grow-and we’re very stubborn. We say we’re stubborn on vision and flexible on details. In some cases, things are inevitable. The hard part is that you don’t know how long it might take, but you know it will happen if you’re patient enough. Ebooks had to happen. Infrastructure web services had to happen. So you can do these things with conviction if you are long-term-oriented and patient. What a wonderful and sustainable moat this is – long-term thinking. Whether you are an entrepreneur or an investor, by thinking and acting (investing) long term, or just by lengthening the time you stay with a good-quality business, you can create wealth you could have never thought of. Like the CEO of a privately held company who can make decisions for the future without worrying about next quarter’s earnings, you can use time arbitrage to benefit from time-tested investment processes without the worry, and often, financial damage that comes from recklessly chasing quick returns. Here is something else I read on Bezos’s long-term thinking in the amazing book Bold … (click to enlarge) 2) Focus on What’s NOT Going to Change This lesson is closely related to the first one above, i.e., long-term thinking. Here’s more on this from Bold … (click to enlarge) “What’s not going to change is what we must focus on!” I tell myself each time I think about the future of Safal Niveshak . And now, Anshul also has to bear with these thoughts, though I am lucky, because this is what he also believes in. “Stability”, as Bezos mentions above, is what causes companies to endure over long periods of time. Look at the biggest wealth creators in the history of the world or in India. Those have been the most stable businesses that have not changed for years. And I am not talking about companies that did not change despite seeing changes in their industry (Nokia (NYSE: NOK ), MTNL, Kodak (NYSE: KODK ), etc.), but rather about companies that have continued to provide tremendous value to customers (the core of any business), even as they change with changing times. So here a few checklist points you must have (on stability ) while looking at investing in businesses: Is the core of this business going/prone to too many changes? Is this business open to disruption? (Anything that can be done via the Internet can be disrupted.) Is the current management too aggressive on growth? Do the customers love this business? Have they loved it for years? Would the business be selling similar products/services 10 years later? If the answer is “No” for the first three questions and “Yes” for the last two, it’s most probably a good business to own (at the right valuations). 3) Focus Intensely on the Customer This lesson holds special relevance for the entrepreneur in me, but I also apply this while analyzing companies. “Do the customers love this business and the products/services it sells?” and “Have they loved this business for the past few years?” is what I ask. In hindsight, my biggest successes in investing have come from businesses that pass this test. Now, it may somewhat be a case of survivorship bias , because some companies that customers have loved have done disastrously for me (like Leela Hotels), but then, the probability of a business doing well for an investor is high when the customers love its products/services over long periods of time. Anyway, this is what I read in Bold … (click to enlarge) 4) Experiment, Experiment… Repeat Honestly speaking, I hate it when companies experiment a lot by venturing into unrelated areas through mindless acquisitions. But continuous experimentation within their circles of competence is an attribute of great entrepreneurs, like Bezos. So this is what I try to apply to my own business. I have had my share of failures and disbelievers – with people calling me names when I started charging a fee for my courses and newsletters, and telling me how these were “doomed to fail when everything is available for free on the Internet.” But I have learned to live with this, for as I mentioned above, my focus is intensely on the value I provide to my readers and subscribers and for a really long period of time. Anyways, here’s Bezos on “experimentation” and “living with being misunderstood and criticised”… (click to enlarge) 5) Accept Failure and Move On Now, this is not something I have learned only from Bezos, simply because I have failed so many times in life that I have been searching for inspiration all around on accepting failure (again and again) but still moving on. I have learned this lesson especially from seeing my daughter grow up. Like when she was just a year old and was trying to take her first steps and repeatedly fell down, she tried again… and again… and again. Sometimes she laughed. Sometimes she cried. Sometimes she laughed and cried at the same time. But she kept trying and trying… laughing and crying. She did not label her experience as a “failure”. She just enjoyed it. Unlike us adults, our babies don’t know the possibility of a failure, so they happily keep falling down until one day they take a few steps, and then a few more. Before long, they’re jumping and running. All their trying pays off. They fall, but never fail. As grown-ups, what if we also simply choose not to fail? What if we treat our mistakes and failures not as things to be avoided, but things to be cultivated? Like Warren Buffett said… You’re going to make mistakes. You can’t play in the game without making any mistakes. I don’t think about it, I just move on. Most business mistakes are irreversible setbacks, but you get another chance. There are two things in life that you don’t get another chance at – marrying the wrong person and what you do with your children. Business, you just go on. It’s a mistake to dwell on mistakes, it’s unproductive. It’s like Mark Twain’s story about the cat that sat on a hot stove – he never sat on a hot stove again, but he never sat on a cold one again either. Life teaches us each day that stuff happens (and sometimes shit happens!), but we don’t need to give each of our experiences a label. Good, bad, hard, easy, success, failure, etc., do not exist but as labels in our minds. All we need to do to hold our head high is to break through these labels. Like here’s what Bezos says on dealing with failure… (click to enlarge) Conclusion: Bezos’s Investing Checklist Over the past two decades, no matter how much its shareholders criticized about all the money Amazon was “wasting”, no matter how often analysts opined that it “could never make money” and “would go bankrupt”, Amazon (and Bezos) has maintained its relentless focus on the long term and on its customers. And this is seemingly the biggest reason it is the only one of the early Internet leaders that is still thriving. Amazon’s approach should be a lesson to all companies, not just Internet companies, and also to us investors (because we also wish to identify such companies that would thrive over the long run). In this regard, I believe it would pay a lot to take Bezos’s advice on where and how to invest through a thought he shared in his 2014 letter to shareholders … A dreamy business offering has at least four characteristics. Customers love it, it can grow to very large size, it has strong returns on capital, and it’s durable in time – with the potential to endure for decades. When you find one of these, don’t just swipe right, get married. This, I believe, is the shortest yet most powerful investing checklist you can ever come across. A business customers love, and which Can grow to very large size, and which Has strong returns on capital, and which Is durable in time – with the potential to endure for decades, and which If you find, you must load up and get married to. Finally, whatever people ultimately will remember Jeff Bezos for, there’s still a lot we can learn from him right now. Anything you’d like to add about him, his legacy, philosophies, or inventions? Put it in the comments section of this post. I look forward to an enlightening conversation and more lessons from one of the world’s best and brightest.