Battle of Factors: Low Volatility versus High Beta

2020 has surprised us all with a number of firsts. Not only did we witness wild swings in the market from one quarter to the next, we also saw an unusual performance of commonly followed factors. While this blog will not attempt to predict factor performance, it will address recent factor behavior and put this behavior into historical context.

The magnitude of market returns during Q2 2020 was impressive, with the S&P 500® returning 20.5% for the quarter. This comes on the heels of a similarly dramatic, albeit negative, showing during Q1 2020, when the index fell by 19.6%. The whipsawing of the market from one quarter to the next is extraordinary when compared with the historical median S&P 500 quarterly return of 3.5% and a median Q2 return of 3.2% (see Exhibit 1).

Factor performance was just as extreme and, in many cases, nearly a mirror opposite of Q1 2020. The S&P 500 High Beta Index (High Beta) and S&P 500 Low Volatility Index (Low Volatility) were the noteworthy outliers during Q2 2020. While High Beta staged a strong comeback, Low Volatility lagged the market and was the worst-performing factor.

It is perhaps not surprising that these factors exhibited the behavior that they did in the Q2 2020. After all, High Beta’s historical return dispersion was the highest among the factors analyzed, while Low Volatility’s dispersion was the lowest (see Exhibit 2). The relative magnitude of their respective bounceback in Q2 2020 makes sense in the context of these factors’ historical return dispersions.

In a further display of how anomalous this past quarter was, Exhibit 2 highlights that nearly every factor’s return was at the extreme of its historical distribution, with a notable exception of the S&P 500 High Dividend Index. We wrote earlier about the reasons for the disappointing performance of dividends in Q1 2020[1] (the underperformance of defensive sectors and low volatility, and the outperformance of growth over value). The bounceback of dividends in Q2 2020 was underwhelming, driven by some of the same dynamics that carried over from Q1 2020.

With High Beta and Low Volatility near the extremes of their historical performance, how have these strategies fared over the long term? High Beta is a curiosity. The Capital Asset Pricing Model[2] tells us that a security’s return should be proportional to its risk. Yet, High Beta’s historical performance has been disappointing (see Exhibit 3). Low Volatility, on the other hand, has had superior risk-adjusted returns, despite its mediocre absolute return profile. The power of Low Volatility has consistently come from its low return dispersion—with smaller drawdowns, the factor has less to gain back after a tough period than a factor with larger drawdowns.

The longer-term return differential between High Beta and Low Volatility is striking (see Exhibit 4). High Beta did indeed have its time in the sun, but the dot-com period of 1998-2000 was relatively brief. The exhibit is truly a testament to the power of compounding and long-term holding discipline. While the Q2 2020 resulted in unexpected returns for many factors, it is the anomalous performance of High Beta and Low Volatility that should give a pause to market players chasing short-term performance.

[1] Cheng, “Why Did Dividend Indices Underperform during the Coronavirus Sell-Off?” 2020

[2] https://en.wikipedia.org/wiki/Capital_asset_pricing_model