- Wealth PMS (50L+)
The 2nd 2023 quarterly rebalance of the CM Low Vol portfolio went out to Capitalmind Premium and CM Low Vol smallcase subscribers yesterday. This post covers a quarterly update of our factor portfolios: CM Low Vol and CM Momentum.
A short introduction to the two portfolios for new readers:
CM Momentum is a long-term quantitative strategy that invests in stocks showing strong price and volume momentum. The underlying principle of Momentum investing, is consistently buying stocks showing stronger relative price momentum offers a strong probability of outperforming the market when implemented over three+ year timeframes. The momentum effect has been well-documented in academic and practitioner research globally.
Our portfolio is sector and market cap agnostic, holds up to 25 stocks selected from all NSE-listed stocks meeting minimum criteria in daily traded volume and market capitalization. The portfolio is reviewed weekly and rebalanced based on a set of price and volume parameters. The portfolio aims to capture the best performers in the market and let the winners run with a disciplined approach. When stocks meeting entry criteria are not found, the portfolio allocates to alternate assets like Gold, Debt or Cash.
CM Low Vol is a long-term quantitative strategy that invests in stocks that have lower volatility than the market. It is based on the principle that stocks with lower past volatility than the market, can deliver higher returns with lower risk over the long term. The Low Volatility effect has been also been documented in various research papers, like ‘The Volatility Effect revisited‘
Our portfolio is sector and market cap agnostic, holds 15 to 20 stocks selected from all NSE-listed stocks meeting minimum criteria in daily traded volume and market capitalization. Historically, the low volatility portfolio holds more large and midcaps due to the selection criteria or relative volatility. The portfolio is rebalanced quarterly based on a set of volatility and diversification parameters.
Table shows the recent performance of the two portfolios over the last 1M to 12M windows.
Chart shows year-to-date performance in 2023.
Markets reversed their decline in April and are 2% up YTD. Momentum has just about kept pace with the Nifty while Low Vol has shown some clear separation since April this year.
We went live with CM Low Vol in late August 2021 which in hindsight was not a great time for a new strategy. And it got tested almost immediately. The market made a high in Oct 2021 that it didn’t scale for over a year.
Surprisingly at the time, historically Low Volatility stocks, not just in India but globally, took a severe beating along with the rest of the market before turning the corner in June 2022. Since then however, Low Volatility stocks have rallied to outperform the benchmark index.
The working hypothesis for why CM Low Vol exists continues to be that since it selects stocks displaying lower relative volatility, it can act as a diversifier improving overall risk-return characteristics of a portfolio that holds both Momentum and Low Vol.
It’s early days still. Chart shows cumulative performance of CM Low Vol since inception in Aug 2021.
CM Low Vol has done slightly better than the benchmark since inception. This is inspite of having to catch up after a poor initial few months.
CM Momentum has been live for nearly four and a half years. Chart shows cumulative performance of ₹100 invested in the CM Momentum portfolio at inception in Jan 2019.
Momentum has had an indifferent time since the market peak in Oct 2021. That this came after a “blow doors off hinges” type preceding 18 months, as the one-year rolling return chart shows, doesn’t make it easier to deal with.
It’s one thing to look at drawdowns in backtests, quite another to live through them.
That distinction is a good reason why factor investing, momentum in particular, might have worked in the long-term. Chart shows the long-term performance of CM Momentum versus the Nifty Total Returns Index (i.e. inclusive of dividends).
For all the doubts over the last year or so, a significantly higher return with comparable volatility and lower drawdowns from peak is what you’d want from an investing strategy.
Chart shows one-year rolling return for CM Momentum and CM Low Vol. The purple line only starts in Aug 2022 since that’s when Low Vol completed one year since going live.
Factor investing makes sense when you think about the underlying rationale for buying stocks meeting certain conditions and the investors typically on the other side of those trades.
Momentum along with Value, are probably the most studied factors in academic literature. Momentum seems to have worked irrespective of time-frames, markets and asset classes as some of the research we collated shows. But like the last 18 or so months have shown, it doesn’t work all the time.
Two ways to deal with periods of frustrating underperformance:
1. Allocate More…Duh!
One way to deal with periods of underperformance in proven factors is actually allocating more knowing that it’s a matter of ‘when’ not ‘if‘ it goes back to outperforming the market. Especially in periods when rolling returns are lower than the long-term averages.
Doing this requires a strong constitution though. These are the exceptional investors who see higher XIRRs than the CAGR of their funds by adding more at lows when last 12-18 month returns have been ordinary. This is the famed behaviour gap, but in reverse.
Not easy to do for most investors.
2. Diversify across Factors
Allocating to meaningfully different factors to avoid feeling the misery of being allocated to the worst-performing strategy at any time.
I remember reading something to the effect that:
“You’re truly diversified only when you’re always uncomfortable about something in your portfolio.” – unknown
For example, the chart below shows how you’d have done if you were allocated on a spectrum from 100% CM Momentum to 100% CM Low Vol. This is only for the time CM Low Vol has been live, which is a narrow sliver of time but still makes the point about diversification’s ability to reduce regrets.
The chart shows the annualised return, volatility and drawdowns from being allocated in different proportions to CM Momentum and CM Low Vol. M100:LV0 = 100% Momentum and 0% Low Vol, M70:LV30 = 70% Momentum, 30% Low Vol and so on.
Since Momentum has had an ordinary time in this specific time-period, the lower the allocation to Momentum, the better you’d have done. Since the two strategies are not perfectly correlated, combining them reduces overall volatility and ensures you don’t have the worst return. Of course, you also wouldn’t have the best return from being allocated to the best-performing factor during that time.
In 2020 and 2021, it was unthinkable to want anything other than Momentum in your portfolio as many investors rotated there from other strategies. In 2022 and 2023, that’s gone to “why would you own Momentum when Value is clearly better?”. Everything is cyclical.
Zigging and zagging between strategies based on recent performance is a surefire way to get below-market returns.
From Fact, Fiction and Factor Investing, which we summarised here
10. Fact: Sticking with factor investing is hard, but worth it
What makes sticking with it particularly hard is that when factors suffer drawdowns, it can be difficult to answer the question “why” (or more accurately, “why now,” aside from observing that investors should expect poor performance from time to time and very poor performance less often but unfortunately sometimes).
Factor performance is difficult to explain in the short run and hence can be difficult to stick with when suffering. This is both a curse and blessing, as it makes factors more difficult to stick with during the difficult times (that’s the curse), but this is what allows factors to bring much-needed diversification to investors’ portfolios (the benefit).
even when they do recover after a drawdown, the recovery will not be smooth and easy. The market, after factors have been out of favor, does not apologize and return all the losses in a day, and even in long protracted large recoveries there will be periods of pain. All of this makes sticking with factor investing tough but commensurate with long-term rewards.
Patience and Discipline because stock returns are lumpy, anyway you look at them.
Chart below is one of our high-level gauges of strength in equities. It shows median one-year trailing returns of the universe of over 1,500 stocks, not just the handful that decide the direction of the index. The shaded band represents the range between the 75th and 25th percentile of one-year returns.
This view shows why, in 2018, every active fund struggled even though the index was marginally up for the year. And why it was incredibly hard to make money in 2011.
Over the last couple of weeks, the median stock has broken into positive after a while. Whether that represents a a false-start like in 2013, or a 2016-like comeback for equities, remains to be seen.
This post is for information and not a recommendation to buy or sell any stock. Investment in securities market are subject to market risks. Read all the related documents carefully before investing.