By CRAIG LAZZARA
We all know that in the long run, the U.S. stock market has performed very well, compounding at well over 10% per year for nearly a century. We also know that sometimes the market performs very poorly, as the S&P 500’s 20% decline in the first half of 2022 reminds us. For an investor who has the luxury of time, the combination of long-term gains with occasional pullbacks is a feature, not a bug; short-term declines are at worst a nuisance, and at best a buying opportunity.
For some investors, however, time is a luxury they do not have. Individuals often have specific goals to which finite time horizons attach. Such investors can benefit from the equity market’s long-term strength, but may have above-average sensitivity to short-term declines.
Defensive factor indices can help resolve this tension
Factor indices in general are designed to indicise active strategies — i.e., to deliver in passive form a pattern of returns that the investor would otherwise have to pay active fees to obtain. Exhibit 1 shows the relative risk and return of several S&P 500-based factor indices. Given the risk/return profiles in the exhibit, we can classify factor indices as either risk enhancers or risk mitigators — mitigators to the left, enhancers to the right.
We think of Low Volatility as the quintessential risk mitigator. Exhibit 2 shows why, comparing two efficient frontiers, one constructed using the S&P 500 and bonds, and the other using the S&P 500 Low Volatility Index and bonds.
For the period summarised in Exhibits 1 and 2, Low Volatility outperformed the S&P 500, but with lower risk. It’s therefore not surprising that an efficient frontier using Low Volatility as the risky asset dominates a frontier using the S&P 500. A 60/40 equity/bond allocation using Low Volatility experienced both lower risk and higher return than a 60/40 mix using the S&P 500.
Importantly, time-sensitive investors could use Low Volatility to improve their risk/return tradeoff. A 60/40 mix of the S&P 500 and bonds produced a total return of 8.3%, with a standard deviation of 8.8%. By using Low Volatility as the equity vehicle, the same return could have been achieved at a lower risk level (6.9%) and with a lower equity exposure (55%). Alternatively, using Low Volatility as the equity vehicle would have increased returns to 9.3% with the same risk level. Indeed, regardless of the starting point, shifting any part of an equity allocation from the S&P 500 to the S&P 500 Low Volatility Index would have resulted in both a reduction in overall risk and an increase in return.
What is true of Low Volatility is also true of other defensive factors. Time-sensitive investors should consider the record of defensive factor indices in mitigating short-term declines while retaining the long-run benefits of equity exposure.
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