Quant Concepts: Low Volatility Growth

Growth and downside protection can get along and outperform by incorporating the right factors in your portfolio, finds CPMS's Phil Dabo 

Phil Dabo 20 November, 2020 | 4:38AM

 

 

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Phil Dabo: Welcome to Quant Concepts' working from home edition. Historically, we have seen similar variables perform well during both market drawdowns as well as recoveries and 2020 is no different. The same variables performed well during periods when the index had negative returns and when the market had positive returns. Today, let's take a look at a low volatility growth strategy that combines factors that have historically provided really good downside protection with factors that have historically provided really good performance when the market is positive. Now, let's start building the strategy.

Let's start by selecting our universe of stocks. We're going to select the Russell 1000 because we want a really good range of small, mid and large-cap stocks. Next, we want to rank our stocks from 1 to 1,000 according to these four important factors. Our first factor is the five-year beta because we want really low market risk. The next factor is the 180-day standard deviation because we want to reduce the price volatility within our strategy. The next two factors are important growth metrics. This one is the industry relative return on equity, which is a standard growth metric and the next one is the industry relative reinvestment rate.

Now, let's take a look at our screens. We're going to start with our buy screens. We're only going to pick stocks that are ranked in the top 20th percentile of our list. We are only going to pick stocks that have really good leverage ratios based on total assets to equity. In this case, we're only going to pick stocks that are in the bottom third of our list based on leverage. The next two factors are momentum characteristics. We're only going to pick stocks that are in the top third of our list based on quarterly cash flow momentum and quarterly earnings momentum.

Now, let's take a look at our sell rules. We've kept the sell rules very simple. In this case, we're only going to sell stocks that are in the bottom 50th percentile of our list, and we're going to sell stocks that have a leverage ratio that is not as strong as everything else in our list. In this case, those are stocks that rank in the top third of our list based on leverage.

Now, let's take a look at the performance of our strategy. We've run the backtest period from January 2000 until October 2020. Over that period, this strategy has provided a 13.8% return, which is 7.6% more than the S&P 500. It's also done that with only 23% annualized turnover. We can see by this column that the strategy has outperformed the index over every significant time period, and it's done that with lower volatility measured by standard deviation if we take a look at this column.

That has contributed to superior risk-adjusted returns measured by the Sharpe Ratio as we can see with this column. And we can also see that the strategy has a lower market risk measured by beta.

If we take a look at this line chart, again, we can see superior risk-adjusted returns where the strategy outperformed the S&P 500 over 70% of the time when we take a look at calendar year returns. It's also nice to look at the market capture ratio, which we can see the overall ratio is very strong, but the downside capture ratio is very good as well. 50% of this portfolio is currently invested in healthcare and technology stocks in the U.S. that have really good downside protection for volatile market environments but still have really good growth characteristics that can capture some of the upside of the market at the same time. You can find the buy list along with the transcript of this video.

From Morningstar, I'm Phil Dabo.

About Author

Phil Dabo  Phil Dabo is Director, CPMS Sales

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