By Mark Barnes, head of US research and product management
The Q1 2020 sell-off left investors asking themselves, “Where should we have invested?” The conventional wisdom is that defensive strategies tend to be best suited to protecting portfolios during market downturns[1]. Defensive factor strategies include Quality and (low) Volatility strategies. However, the COVID-19 downturn presents us with a puzzle: while Quality preformed relatively well, (low) Volatility did not. Why didn’t Volatility protect portfolios when markets were down?
In a previous blog we reviewed the performance of the Russell 1000 factors (R1000) during the first quarter by dividing the quarter into the period before the market peaked on February 19, and the period after that. One observation was that the performance of the Volatility factor had been relatively flat during both periods. This blog looks deeper into this surprising observation.
Chart 1 shows the average volatility[2] percentile of each of 10 roughly equal performance buckets of stocks. For example, the worst performing decile of stocks (bucket 1) in the early period (burgundy bars) had the highest volatility, with an average volatility percentile of about 70, which is well above the median of 50. However, the highest performing bucket had the second highest average volatility, while lower volatility levels were seen in the middle performance buckets. This “smile” in payoff led to the flat performance of the Volatility factor in the first period.
What was surprising was that during the sell-off, Volatility continued to deliver a flat performance, since we generally expect low volatility stocks to protect a portfolio in falling markets. However, the gray bars in Chart 1 show that the best performing bucket had a high average volatility during the sell-off.
To gain some insight into why the best performing stocks tended to have higher volatility, we looked at the characteristics of the top decile performing industries. Table 2 shows the number of stocks, which were benchmark weighted, renormalized benchmark weight and the average volatility percentile by industry. The bulk of the capitalization is in Consumer Services and Health Care, with the Health Care stocks having an average volatility percentile of 61.6. It is interesting to note that Utility stocks did not appear in the top performing decile, given that they are considered among the most defensive. What does this industry representation indicate about investors reaction to the crisis? What did they consider to be safe stocks?
To get even more granularity, Table 3 shows the twenty stocks with the best performance in the later period. Investors’ views of safety begin to emerge. Specifically, there were many COVID-19-related stocks: biotechnology companies working on new COVID-19 drugs; stocks related to working remotely (Citrix, Digital Realty, CoreSite Realty and Docusign); food, and even video games and pizza delivery companies, which were related to the crisis. These stocks are generally not perceived as low volatility stocks, except for Clorox, which was a high-profile participant in the fight against the virus infection.
So, why didn’t (low) Volatility protect portfolios? The reason is that the defensive move during this sell-off was not a move to low volatility stocks, but rather one to stocks expected to do well during the COVID-19 crisis, regardless of their volatility. Furthermore, this market sell-off had well-known causes and investors took this into account when positioning their portfolios.
Not all sell-offs are the same, and this one was certainly characterized by idiosyncratic reaction to the virus crisis itself.
Subscribe to the blog
Reference
[1] This performance is based on the Russell 1000 Target Exposure single factor indexes.
[2] Volatility is calculated as the standard deviation of weekly returns over the previous five-year period.
© 2020 London Stock Exchange Group plc and its applicable group undertakings (the “LSE Group”). The LSE Group includes (1) FTSE International Limited (“FTSE”), (2) Frank Russell Company (“Russell”), (3) FTSE Global Debt Capital Markets Inc. and FTSE Global Debt Capital Markets Limited (together, “FTSE Canada”), (4) MTSNext Limited (“MTSNext”), (5) Mergent, Inc. (“Mergent”), (6) FTSE Fixed Income LLC (“FTSE FI”), (7) The Yield Book Inc (“YB”) and (8) Beyond Ratings S.A.S. (“BR”). All rights reserved.
FTSE Russell® is a trading name of FTSE, Russell, FTSE Canada, MTSNext, Mergent, FTSE FI, YB and BR. “FTSE®”, “Russell®”, “FTSE Russell®”, “MTS®”, “FTSE4Good®”, “ICB®”, “Mergent®”, “The Yield Book®”, “Beyond Ratings®” and all other trademarks and service marks used herein (whether registered or unregistered) are trademarks and/or service marks owned or licensed by the applicable member of the LSE Group or their respective licensors and are owned, or used under licence, by FTSE, Russell, MTSNext, FTSE Canada, Mergent, FTSE FI, YB or BR. FTSE International Limited is authorised and regulated by the Financial Conduct Authority as a benchmark administrator.
All information is provided for information purposes only. All information and data contained in this publication is obtained by the LSE Group, from sources believed by it to be accurate and reliable. Because of the possibility of human and mechanical error as well as other factors, however, such information and data is provided "as is" without warranty of any kind. No member of the LSE Group nor their respective directors, officers, employees, partners or licensors make any claim, prediction, warranty or representation whatsoever, expressly or impliedly, either as to the accuracy, timeliness, completeness, merchantability of any information or of results to be obtained from the use of FTSE Russell products, including but not limited to indexes, data and analytics, or the fitness or suitability of the FTSE Russell products for any particular purpose to which they might be put. Any representation of historical data accessible through FTSE Russell products is provided for information purposes only and is not a reliable indicator of future performance.
No responsibility or liability can be accepted by any member of the LSE Group nor their respective directors, officers, employees, partners or licensors for (a) any loss or damage in whole or in part caused by, resulting from, or relating to any error (negligent or otherwise) or other circumstance involved in procuring, collecting, compiling, interpreting, analysing, editing, transcribing, transmitting, communicating or delivering any such information or data or from use of this document or links to this document or (b) any direct, indirect, special, consequential or incidental damages whatsoever, even if any member of the LSE Group is advised in advance of the possibility of such damages, resulting from the use of, or inability to use, such information.
No member of the LSE Group nor their respective directors, officers, employees, partners or licensors provide investment advice and nothing contained in this document or accessible through FTSE Russell Indexes, including statistical data and industry reports, should be taken as constituting financial or investment advice or a financial promotion.
Past performance is no guarantee of future results. Charts and graphs are provided for illustrative purposes only. Index returns shown may not represent the results of the actual trading of investable assets. Certain returns shown may reflect back-tested performance. All performance presented prior to the index inception date is back-tested performance. Back-tested performance is not actual performance, but is hypothetical. The back-test calculations are based on the same methodology that was in effect when the index was officially launched. However, back- tested data may reflect the application of the index methodology with the benefit of hindsight, and the historic calculations of an index may change from month to month based on revisions to the underlying economic data used in the calculation of the index.
This publication may contain forward-looking assessments. These are based upon a number of assumptions concerning future conditions that ultimately may prove to be inaccurate. Such forward-looking assessments are subject to risks and uncertainties and may be affected by various factors that may cause actual results to differ materially. No member of the LSE Group nor their licensors assume any duty to and do not undertake to update forward-looking assessments.
No part of this information may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without prior written permission of the applicable member of the LSE Group. Use and distribution of the LSE Group data requires a licence from FTSE, Russell, FTSE Canada, MTSNext, Mergent, FTSE FI, YB and/or their respective licensors.
