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Capitalizing On The Low Volatility Anomaly: An Introduction

Summary Introduces readers to a series on the Low Volatility Anomaly, or why lower risk investments have outperformed higher risk investments over time. Sets the stage for a more academic approach to detailing Low Volatility strategies. Breaking this thesis down into fundamental pieces could provide for a more consumable narrative for readers and provide an opportunity for real-time feedback as the study is completed. The alpha we are collectively seeking in this community is investment outperformance on a risk-adjusted basis. As a contributor, describing to readers a readily implementable strategy that has consistently and meaningfully outperformed the broader market over the history of modern finance should be a chief goal. I have referenced such a strategy, the Low Volatility Anomaly, in a litany of articles over the years, including in my well received recent series on 5 Ways to Beat the Market . Given the long-run structural alpha generated by low volatility strategies, I want to dedicate a more detailed discussion of the efficacy of this style of investing. Providing a detailed theoretical underpinning of the strategy or detailing multiple examples of its outperformance can prove challenging in a single blog post. In a series of articles, I am going to describe the theoretical underpinning for the Low Volatility Anomaly and empirical evidence of its existence across markets, geographies, and long-time intervals. For most readers, this will not be a summer blockbuster. I am going to attack this series of articles in a more academic approach, linking to scholarly articles by authors who are wiser than me for support of my thesis. By breaking this series into themed segments, I hope it is more consumable for readers wishing to explore the merits of this strategy. I previously had good success with a more long-form academic undertaking through the post, A Lecture on Yield , and I hope readers enjoy this series even more. Before we delve into an introduction on the Low Volatility Anomaly, I want to pictorially demonstrate the strategy. Since pictures are worth a thousand words (and I am preparing to write several thousand of them in this effort), a couple of pictures should be a good place to start. Below is 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. Pictorial Depiction of the Low Volatility Anomaly (click to enlarge) Below I capture annual total returns of the Low Volatility, High Beta, and broad market indices, and provide summary return and risk statistics, illustrating the risk-adjusted outperformance of Low Volatility stocks. Note: Index data is available back to November 1990. Index data is back-tested based on this methodology, which is hypothetical and not actual performance. While this is not the only example of Low Volatility strategies outperforming their higher beta cohorts or the market in general, it provides a good jumping off point for this discussion based on the broad domestic equity market benchmark. In the graph and chart, one can see that the Low Volatility Index produced higher absolute returns with only three-quarters of the market risk and less than half of the risk of the High Beta Index as measured by variability of returns. We will examine both longer-time interval samples of outperformance and greater alpha in other examples throughout this series, but I hope these historical returns frame the Low Volatility Anomaly at the outset. Why has this anomaly persisted for so long? The next article in this series will begin to discuss the theoretical underpinning for the Low Volatility Anomaly, combining elements of market structure and a touch of behavioral economics. The next section will also feature expansive market studies of the persistence of the Low Volatility Anomaly. 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. Disclosure: I am/we are long SPLV, SPY. (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.

Is Elevated Volatility On Modest Losses Normal?

By Ronald Delegge Stock market volatility creeps up when most investors least expect it. But even more intriguing about the latest upward explosion in equity volatility is that it occurred on small percentage losses in major stock index benchmarks like the S&P 500 and Russell Small Cap 2000. From June 14 to July 9, the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) posted a modest decline of just -1.96%. Meanwhile, the VIX soared +44.92% on the S&P’s relatively modest losses over that period. (See chart below) For perspective on how huge of a jump in S&P 500 volatility that represents, the Russell 2000 volatility index increased just +34.72% on a decline of -2.37% in U.S. small cap stocks over the same time frame. Although small caps are riskier than large caps, volatility readings were substantially higher for large caps despite their relative safety. (click to enlarge) Just ahead of the double digit spike in the S&P 500 Volatility Index, we wrote to our Technical Forecast to readers on June 14: The recent May low in the VIX (on May 21 @ $12.11) occurred on the exact same day the S&P 500 reached a new all time high (also May 21 @ $2131). That is no coincidence. The relationship between the VIX and the S&P is extremely intertwined, especially on a daily basis. As the VIX falls, the S&P rises and vice versa. If there is a floor in the VIX, and the relationship is expected to hold, then that means there is a ceiling for the S&P. We are seeing that floor in the VIX and ceiling in the S&P play out in 2015. Although the latest pop in volatility on modest losses could be a prelude of future swings of similar or even larger magnitude, the best way to capitalize is always the same: Be ready. For ETF investors, there are multiple ways to trade short-term volatility. The ProShares Short VIX Short-Term Futures ETF ( SVXY) aims for -1x daily opposite exposure to the VIX while the ProShares VIX Short-Term Futures ETF ( VIXY) aims for exposure to an index of VIX futures contracts with short-term expirations. Disclosure: No positions Link to the original piece on ETFguide.com Share this article with a colleague

The SEC Is Going Too Far On ‘Clawback’

Summary Andrew Ross Sorkin of DealBook reported that the new SEC proposal could obligate all publicly traded companies to recover incentive-based compensation from executives contingent on certain events. If the proposal is passed, it would result in widespread ramifications for Corporate America. In this piece, I detail the potential negative consequences that I believe are the most salient to the discussion at hand. Ramifications would revolve around the misalignment of interests between shareholders and management. Increased compliance costs and reduced market liquidity would be possible consequences as well. Investors should consider allocating capital to international corporations not subject to SEC regulation. “Clawbacks” are coming Recently, New York Times DealBook founder Andrew Ross Sorkin reported that the Dodd-Frank regulation, which aims to overhaul the financial system post-2008 requires the Securities & Exchange Commission to devise a rule relating to “clawbacks”. As a quick reminder to readers who are not familiar with the term, clawbacks are provisions that are included in employment contracts which allow the principal (i.e. the employer) to limit bonus compensation upon the occurrence of certain events specified in the employment contract. Moral hazard and measures taken to mitigate the problem The reason why clawbacks generate a great deal of discussion is largely as a result of the sub-prime mortgage crisis. Public and political commentators have opined that one major factor contributing to the crisis was that of moral hazard. Pre-2008, traders could take a lot of risks for a chance at an outsized payout. If it worked, the trader would be compensated heavily. If the trade failed, the trader would be fired. However, the downside risk was minimal as the trader could simply get employed at another firm. With the possibility of an outsized payout and minimal downside risk, incentives were highly asymmetric. Thus, to mitigate the problem of moral hazard, clawbacks were proposed by the SEC. However, I believe that the Commission is going too far as its current proposal would extend to all publicly-traded companies , instead of just financial institutions. Essentially, the new proposal would obligate public companies to recover incentive-based compensation from executives for up to three years if they ever have to restate their earnings. Due to the all-encompassing nature of the provision, I believe that this topic should be of great interest to investors who invest in corporate America (NYSEARCA: SPY ) – in other words, nearly every investor out there. The proposal is deceptively simple. Despite its simplicity, I believe that there are severe ramifications that may materialize if it is passed. These ramifications primarily revolve around the misalignment of interests between shareholders and management . In his piece, Mr. Sorkin explained briefly how base/incentive compensation may be affected. Due to his brevity, I believe that readers may not have grasped the essence of his article. Therefore, I will expand upon the points he made. Before I do that, I believe that some context is required. A brief history of compensation Historically, employers compensated employees with a fixed base salary that grows by a small amount (usually somewhat correlated with inflation) every year. However, employers soon realized that this model was not sufficient to motivate their employees. As they were being paid a fixed base salary, employees were not incentivized to strive for performance – they were happy to complete the minimum required of them. After all, there was no need to outperform; there were no financial rewards for outperformance. Lip service might be given as a courtesy, but we all know what that is worth. In a bid to motivate outperformance, employers soon started offering bonus compensation to employees that exceed what was required of them. This bonus compensation can come in many forms – restricted stock, stock options, etc. However, they all have one thing in common. They were tied to performance. Some may be tied to sales targets, others may be tied to profit targets. This compensation model worked well for a while. However, employees soon found that it was a better idea to take stratospheric levels of risk for a probability at an immense financial payout. This produced the rogue traders that I believe that many readers are familiar with (London Whale, Nick Leeson, etc). The new SEC proposal The Commission’s new proposal is intended to mitigate the problem of moral hazard that comes with the asymmetric compensation model discussed above. The idea is rather simple – an employee that takes projects with unusually high amounts of risk may manage to achieve success in the short-term, but in the long-term the proposition is likely to blow up. Said another way, profits in the short-term might be outsized, but may need to be restated in the future (after being marked-to-market, for example). Thus, the employee would be compensated on the basis of the restated profits (which are typically much lower). In theory, it seems like it would work out. However, the situation is likely to manifest very differently in practice. Faced with reduced bonus compensation, executives are likely to take one of two routes: increase base compensation substantially to offset the decrease in bonus compensation, or increase bonus compensation to such a height that would ensure bonus compensation remain at pre-proposal levels post-proposal. Both routes are equally dismal for shareholders of corporate America. Suppose base compensation was increased in order to offset the decrease in bonus compensation. In this case, the situation would simply revert back to what it was historically – where employees were compensated with a salary that was largely fixed. Incentives for outperformance would be minimal. Thus, management would not be motivated to strive for performance. It is likely that management would simply be concerned with keeping their jobs, thus reducing the likelihood of them taking on large projects that would allow their company to grow. After all, there is no incentive to. As a result, shareholders of corporate America like you and me would be paying more for management that is content with maintaining the status quo. Growth realized by the S&P 500 has been sluggish in recent years, and the new proposal would exacerbate the problem. Alternatively, suppose that bonus compensation was increased to such a height that would ensure bonus compensation remains at pre-proposal levels post-proposal. In this situation, the net effect on bonus compensation would be minimal. However, as this scenario implicitly requires bonus compensation to be tied to a larger percentage of performance, the incentive to take on extremely high-risk projects would be heightened even further. In a nutshell, the problem of moral hazard would be amplified. Shareholders would be footing the bill once again. Expect this to contribute to a repeat of the 2008 crisis. In addition to the above, I believe that there other ramifications to consider as well. Other possible consequences Due to the fact that restatements of earnings tend to be as a result of an honest accounting error for the most part, corporate America as a whole is likely to hire more compliance personnel in a bid to minimize the possibility of error. Although compliance personnel play an important role, they do not generate any revenue or profit for the company. They are a necessary cost, but a cost nonetheless. For particularly large organizations, the increase in hiring of compliance personnel is likely to be substantial, which will materially reduce their bottom line. Once again, shareholders end up picking the tab. Recent regulation that called for banks to hold more capital (per Basel standards) have greatly reduced market liquidity . I opine that if this new SEC proposal was passed, liquidity would decline even further. It is no secret that financial institutions such as Citigroup (NYSE: C ), Goldman Sachs (NYSE: GS ) and Bank of America (NYSE: BAC ) are market-makers. Market-makers provide liquidity to the markets. They stand by willing to sell or purchase securities to and from willing market participants. Without a doubt, their role is a vital one. Recall that the new SEC proposal allows bonus compensation to be recovered in the event of a restatement of earnings. Mark-to-market gain/losses are one example of one such event. As bonus compensation is typically far greater than base compensation, executives of financial institutions are likely to cut back their presence in market-making in order to reduce the probability of the firm suffering from huge mark-to-market losses. Due to increased illiquidity, investors should expect increased volatility if the proposal is passed. Conclusion The new proposal proposed by the SEC aims to rein in outsized compensation. Despite its well-intended nature, the proposal is likely to result in widespread ramifications across corporate America if it is passed. No matter how you slice it, a misalignment of interests between shareholders and management are sure to occur. Increased compliance costs should follow as well. When all is said and then, public shareholders would be the one footing the bill. Additionally, the proposal could also result in a further diminishing in market liquidity, which would increase illiquidity. Although the proposal has not been passed yet, I believe that there is a high likelihood that it would be. The general public has always been inundated and resentful towards executives who command high levels of compensation. A proposal that aims to reduce compensation levels would likely be very popular. However, such proposals may have unintended consequences as detailed above. As these consequences are far-reaching, I believe that every investor should take note of the situation and perhaps consider investing abroad where public companies are not subject to SEC regulation. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (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.