Sometimes the Safety Nazis have a point

I have to apologize for my recent blogging hiatus. My financial planning studies have put an end to my golf, and I’ve been too time poor to blog. However, my studies have come in a distant second next to my two latest research projects. In this post, I’ll go into detail about the first of these: the low risk anomaly. In a subsequent post I hope to outline my new approach to selling volatility and hedging risk.

But first, in my recent fund letter, I mentioned that I hoped to add other assets to the portfolio for greater diversification. This begs the question of how. Previously, I considered the “tactical allocation” strategy (TAA), which is all the rage at the moment. If readers are not familiar with this notion, I would direct you here or here or here. Perhaps the simplest system is Meb Faber’s, in which you buy an asset (stocks, bonds, property) if the price is above its 10-month moving average, and move to cash if it dips below. Over the very long term it does provide some measure of protection from bear markets, but performance can lag badly during strong bull markets. The chart below (taken from Faber’s white paper) shows the performance since 1973, and performance since the great depression is similar. All the TAA systems out there are broadly similar, so I won’t bother differentiating between them.

One thing that isn’t made clear from this bird’s eye perspective is that performance can be very bad for a very long time. I’m also a little bit skeptical of the results because if you rebalance the portfolio in the middle of the month, instead of at the end of the month, performance drops off badly. The other issue is that, with the exception of the worst sort of market crashes, such as 2008, the systems referenced above are generally pretty terrible at timing the market, especially for the assets I’m interested in adding – large caps and bonds.

My solution for large caps comes from research that’s been around since at least the 1970s when Robert Haugen first noticed that low risk stocks often outperformed high risk stocks. Obviously, this isn’t supposed to happen. We usually expect to get paid to take risk, so buying riskier stocks should generate higher returns. I first became aware of this anomaly, often referred to as the low volatility anomaly, through Eric Falkenstein’s blog (his books are great btw). Unfortunately, Falkenstein rarely blogs now since moving to a hedge fund. It was also through his blog that I became aware of a gem of a book called “High Returns from Low Risk“, by Pim van Vliet. I devoured this book in a single sitting and loved the simple presentation of such a powerful strategy.

The chart below, which I took from the data set on  van Vliet’s book website, shows the performance of his “conservative” portfolio. I don’t want to give away his methods here, but I urge everyone to read his book if they want a no-nonsense and robust way to invest. I’ve been agonising for years over which value metrics to add to my stock investing. This book finally brought everything into focus for me, and I knew I had to add low vol investing to my toolkit.

As an aside, van Vliet’s system is used by a number of fund managers, and not just for stocks. This piece, for example, shows that the intersection of low volatility, carry, value and momentum can be used to trade other asset classes, such as bonds. What I love about this approach is that it gets right to the heart of what an active fund manager should do: provide decent returns without the same level of risk that an investor would usually expect. For my purposes, it provides a perfect complement to my small cap strategy which can go through extended periods of underperformance.

Up next (soon hopefully), how to hedge without losing your shirt.

 

3 thoughts on “Sometimes the Safety Nazis have a point”

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