Quant Concepts: High Performing Low Volatility

Phil Dabo finds a strategy with superior up- and down- side capture ratios throughout different market cycles

Phil Dabo 12 February, 2021 | 12:11PM



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Phil Dabo: Welcome to Quant Concepts' working from home edition. With all of the volatility in markets these days, it's a good idea to look for companies that can protect your portfolio from downside risk. However, there's also a lot of uncertainty in the market, so you may want to hold stocks that will participate in a market recovery. Supply-side economics assumes that GDP growth translates into higher earnings per share, which ultimately contributes to an increase in stock prices.

Today, let's take a look at a strategy that focuses on lower volatility stocks that can participate in a market recovery. As always, we're going to start by ranking our universe of stocks. We've selected all 700 stocks in our Canadian database so that we can select a wide range of companies, including small-cap and large-cap stocks. Overall, the strategy has had an average market cap of 9 billion or more. We're going to rank our stocks from 1 to 700 according to six key factors.

The first two factors relate to volatility. We want stocks that have lower market risk as measured by beta and lower price risk as measured by the 180-day standard deviation. Our next two factors are the quarterly earnings momentum and quarterly earnings surprise. We want companies that are starting to increase their earnings and are beating analyst expectations. This will help when the economy starts to expand.

Next, we want a company with higher ROE, but we also want it relative to the industry that they are in. This is because some industries naturally have a higher ROE than others, such as the tech sector. The last variable is our price change to 12-month high because buying stocks that are trading close to their previous 12-month high tend to keep doing well.

Now, let's take a look at our buy rules. We want stocks that are ranked better than 90% of their peers. We don't want stocks that are in the bottom third of our list based on earning surprise. We want stocks that are better than 90% of their peer group based on the price change to 12-month high. Our last buy rule is the Morningstar quantitative health score. This is a proprietary measure indicating a company's financial health based on the firm's leverage. A higher score indicates lower leverage and less likelihood the company will fall into financial distress.

Now, let's take a look at our sell rules. Our sell rules are very simple. We want to sell stocks that fall to the bottom half of our list, and we want to sell stocks when their financial health deteriorates and falls out of the top third of our list.

Now, let's take a look at performance. The benchmark that we used is the S&P/TSX and we tested this strategy from January 2006 to January 2021. Over this time period, the strategy generated a very strong 14.6% return, which is 12.1% higher than the benchmark, with only a 50% annualized turnover. We can see by looking at the annualized periods that this strategy has outperformed the benchmark over every significant time period. It's done so with higher risk-adjusted returns as measured by the Sharpe Ratio, and as expected, it has slightly lower market risk as measured by beta.

We can see by looking at this chart that this is a strategy that has consistently outperformed the benchmark and we can see by the up- and down- side capture ratios that this is a strategy that has performed well throughout different market cycles. This is a great strategy to consider if you want some stocks that have lower volatility relative to the S&P 500. In addition to having a lower volatility profile, these stocks will also benefit from a short-term improvement in earnings per share. With the objective of achieving good downside protection, these stocks can also participate when the economy fully recovers with the idea that GDP growth will transform into earnings growth and ultimately increase the stock price.

You can find the buy list along with the transcript of this video. From Morningstar, I'm Phil Dabo.

Buy list

For a larger image of the buy list, click here.

About Author

Phil Dabo  Phil Dabo is Director, CPMS Sales

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