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. 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 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.
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 This performance is based on the Russell 1000 Target Exposure single factor indexes.
 Volatility is calculated as the standard deviation of weekly returns over the previous five-year period.
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