CPM Investing LLC - Research Publications
When starting an investment program, it is important to have realistic performance expectations. In the Focused 15 Investing program, we create high-returning, low-variability (or low- volatility) model portfolios that increase wealth in a reliable way. Lower variability is a good characteristic: it means that returns are smoother over time.
However, evaluating the performance of low variability portfolios over a short time span is surprisingly difficult. Some commonly used methods for evaluating short-term performance can be misleading and fail to reveal the benefits of a low variability strategy.
In my communications with subscribers, I use the term variability, although in the investment industry, the term “volatility” is most commonly used. Low variability can make it difficult to evaluate performance over short periods of time—anything less than three or four years.
Over a long period of time, as shown in the chart above, the loss-avoidance strategy is very attractive. The returns of the Focused 15 model portfolio are shown in blue. The values are shown on a log scale, so this relatively straight line is a really positive performance pattern. The tan line represents one of the comparative benchmarks for the portfolio, which I call the upper risk mix. The upper risk mix consists of same ETFs that are in the model portfolio but held at constant weights in an aggressive stance over time, which makes it a good reference for the evaluation of the actual traded model portfolio. Comparing the blue and tan lines, the blue model portfolio is clearly better than the tan line representing the upper risk mix; the ending points at the far right of the chart shows that the end of the blue line is much higher than the end of the tan line.
Even though the general impression of the chart is that the blue line for the model portfolio does quite a bit better than the tan line for the upper risk mix, it is very important to note that although this portfolio is very strong, it does underperform at certain points in time. If you look back to an earlier period—say, 1996, at the far left of the chart—you can see that both lines move together and keep pace with each other. If you look closely, you can see that the tan line actually moves higher than the blue line of the model portfolio over a few periods. This means that the model portfolio did worse than the upper risk mix. Thus, even though there are periods when the traded model portfolio underperforms the upper risk mix, it is clear that that we really want that blue line of the model portfolio over long periods of time.
There is sometimes an unfair harshness involved in evaluating the returns coming from a low-volatility portfolio, as shown in the green box at the bottom right of the above chart. In the column labelled year-to-date (YTD) 2019 period (which represents the January 1 through April 30 period), the model portfolio returned 8%. The upper risk mix, which, again, consists of the same ETFs as the model portfolio held at constant weight in an aggressive stance, returned 14%. This means that the model portfolio underperformed by 6 percentage points, which is quite a bit. But this is where what I call the tyranny of low-volatility investing comes in. We see that the blue line, the model portfolio, is clearly superior to the tan line over a long time horizon. But if we look at short periods of time—four, six, seven months, or even a year— a low volatility model portfolio can underperform significantly.
Many portfolios in the industry—the mutual funds that you might purchase or investment managers you might work with—aim to give you the index return plus a little bit extra. There are many reasons why this is a common type of investment product that professional firms offer. One of the reasons is that it is very easy to evaluate performance.
The chart above shows the performance pattern of a model portfolio that fits the more common type of investment in the industry. The green line indicates the value of an index, and the purple line indicates the value of the traded portfolio: the portfolio that aims to outperform the index over the time period shown, which is from January 7, 2000 through April 19, 2019. In this example, the traded portfolio has done a good job of outperforming its index. We can see that because the slope of the purple line is steeper than the slope of the green line.
That means that we are adding a little bit of extra of return on a regular basis compared to the benchmark index. Over the period of 2003 to 2008 or 2009, and from the period of 2009 and 2010 to mid-2019, there is an expanding gap between the traded portfolio and its index. This portfolio gives the benchmark return plus an extra (sometimes called “alpha”), which makes performance measurement easy on a short-term basis – simply look at the return over and above the index return. But the key issue that we are focused on is the area from 2007 to 2009 on the chart: the deep losses that occur over a period of months. We want to avoid these losses.
Now we are back looking at the loss-avoidance portfolio over long term. The blue line of the model portfolio is obviously better than the tan line of the upper risk mix.
It is important to recognize that the attractiveness of the blue line depends a great deal on the starting point of the evaluation period. Compared to the earlier slide that shows the loss-avoidance portfolio that began in 1996, this one begins in January 2000. That was the top of the market after the internet boom. By and large, the equity markets declined to 2003, moved up to a peak in 2007, down in 2009, and then began a long-term trend up. While the blue line is clearly better when viewed over a longer time horizon, this image is heavily influenced by the starting point.
If we go to a more recent staring point, such as July of 2014, the blue line is still a more attractive performance pattern. But it looks less attractive than the same portfolio over a longer-term time horizon.
The portfolio gains some returns compared to its upper risk mix, during this period. It avoids some of the losses, and it performs well in this long upward trend. It avoids the loss in December of 2018 and has moved higher.
But if we look over a more recent perspective, that same performance pattern, the same model portfolio, actually looks less attractive. The chart above is through April 19, 2019. The green line indicates the model portfolio, and the tan line represents the upper risk mix. The model portfolio has clearly underperformed the upper risk mix. If you focus just on that number, you would say that there’s something wrong with the strategy, it’s not working.
Many investment professionals in the industry are evaluated by their companies for how well they perform YTD. It’s not the only component of the evaluation, but it is very important. Low-volatility strategies often have this kind of performance pattern, where performance lags their benchmarks over certain calendar periods.
The tyranny of low volatility investing tends to occur when a calendar period starts at a low point in a performance cycle. The chart on the left above shows the period from July 16, 2018 April 19, 2019. The tan line represents the URM. The major decline in this period took place at the very end of 2018. The model portfolio missed much of that decline and then moved higher since then as the market recovered. But if we start the evaluation period right at the bottom of the performance cycle on December 31, 2018, we get what appears at this chart right - the model portfolio significantly underperforms the URM from January 2019 through April 19, 2019.
The most important take-away from these examples is that it is important to know of the tyranny of low volatility investing. If you understand what is happening, you can avoid making poor decisions about the long-term strength of an investment program.
Again, we don’t have that issue with the index return plus extra, which is more common in the industry. In this period showing 2003, right from the bottom of the market, the traded portfolio does quite a bit better than its benchmark, which is considered to be more attractive. When we are evaluating a low-volatility approach, we have to be very careful when we see a comparative performance number that is not attractive when the time period is very short.
Looking back at this very long time horizon as in the chart above, which begins in 1996, the blue line underperforms the tan line at first, but then it continues to move higher while there are losses in the benchmark. But even so, over the most recent four- to five-month period shown on the chart, we were underperforming the upper risk mix. That’s where the tyranny of low volatility investing comes in. We have to be very careful in how we evaluate short-term returns when we’re dealing with the low volatility portfolio.
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