The Downside Volatility

The below post was graciously written and provided by Timo Pfeiffer, Head of Research & Business Development, and Yayin Su, Quantitative Research Analyst, both from Solactive AG. 

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The Downside Volatility

NOVELTY IN FACTOR INVESTING – DOWNSIDE VOLATILITY (1)

Since the 2008 financial crisis, more emphasis is put on risk management. How do investors quantify the risk of an investment? One measure in a portfolio context is variance, which is the average dispersion around the mean return. The problem is that variance treats negative and positive deviations equally. But positive returns do not jeopardize your portfolio, as such positive deviations shouldn’t be penalized – one alternative to the classical method is to use downside volatility, which only considers the volatility of negative returns. To showcase the distinction between variance and downside volatility, let’s consider the following portfolios: Portfolio A with returns [-5%, -5%, -5%] and Portfolio B with returns [2%, 3%, 5%]. Standard deviation (the square root of variance) are 0% and 1.25% for A and B, respectively. This indicates that A is a less risky portfolio. Meanwhile, downside volatility shows that B is less risky. The downside deviations (the square root of downside volatility) are 5% and 0%. Which approach is more justified? Intuitively, a risk-averse investor will not prefer stable negative returns to volatile positive payoffs. This simplified example suggests that a downside volatility strategy better captures risk and aligns with a rational investor’s preference.

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1 For more details, please refer to Solactive Research Paper, “Minimum Downside Volatility Indices”.  

How does a downside volatility strategy perform in practice? We simulate historical performance of two strategies – minimum downside volatility versus minimum volatility, with the Solactive US Large & Mid Cap Index as the selection pool. To construct these strategies, we select 100 stocks that minimize the downside volatility (variance) of the portfolio. Sector bounds and turnover constraint are also implemented to avoid large undesired sector allocations and high turnovers. We compare these strategies to the benchmark, the Solactive US Large & Mid Cap Index.

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 As demonstrated in Figure 1 and Table 1, risk measures of the minimum downside volatility index (standard deviation and downside deviation) are substantially lower than those of the minimum volatility index and the benchmark. Moreover, the annualized return of the minimum volatility index is the highest. The resulting risk-adjusted returns (Sharpe ratio and Sortino ratio) are materially improved. Over long time, the minimum downside volatility index amplifies the low risk anomaly by generating lower deviation than the minimum volatility index.

A YEAR-TO-DATE SNAPSHOT

Tense geopolitical climate in Europe, constant threat of a pending “trade war”, denuclearization negotiations in the North Korean Peninsula, the first half of 2018 has witnessed bursts of turbulences which have alerted investors against risk. This brings us to a question: did a downside volatility strategy continue to outperform?

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Year-to-date performance in Table 2 and Figure 2 illustrates the defensive nature of a downside volatility strategy: compared to the minimum volatility index, the US Large & Mid Cap Minimum Downside Volatility Index generated a positive annualized return of 4.38%. Its Sharpe ratio (0.40 vs. 0.03) and Sortino Ratio (0.51 vs. 0.04) are also significantly improved.

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CONCLUSION

During an extended time, a well-constructed strategy with downside volatility as a risk measure harvests the low risk anomaly without compromising upside potentials. It showcases over performance compared with a plain volatility strategy. Eventually, within the framework of adaptive wealth strategies, the downside volatility factor is the novel investing method during volatile periods.

 

DISCLAIMER

Solactive AG does not offer any explicit or implicit guarantee or assurance either with regard to the results of using an Index and/or the concepts presented in this paper or in any other respect. There is no obligation for Solactive AG - irrespective of possible obligations to issuers - to advise third parties, including investors and/or financial intermediaries, of any errors in an Index. This publication by Solactive AG is no recommendation for capital investment and does not contain any assurance or opinion of Solactive AG regarding a possible investment in a financial instrument based on any Index or the Index concept contained herein. The information in this document does not constitute tax, legal or investment advice and is not intended as a recommendation for buying or selling securities. The information and opinions contained in this document have been obtained from public sources believed to be reliable, but no representation or warranty, express or implied, is made that such information is accurate or complete and it should not be relied upon as such. Solactive AG and all other companies mentioned in this document will not be responsible for the consequences of reliance upon any opinion or statement contained herein or for any omission.

An investor cannot directly invest in an index.  Returns shown are calculated by a third party vendor, Solactive AG.  The date range for historical, back-tested information for the Adaptive Wealth Strategies U.S. Factor Index (the ‘index’), is September 1, 2001 through August 7, 2018.  Past performance – both actual and back-tested – is not an indication or guarantee of future performance.  All performance data is shown without any associated fees or trading costs.  No information given is intended to be investment advice or a recommendation for any kind of investment decision or asset allocation and should not be relied upon advice.  Charts and graphs are provided for illustrative purposes only.  Index returns shown may not represent the results of the actual trading of investable assets.  Back-tested performance is not actual performance, but hypothetical based on the same methodology that was in effect when the index was officially launched on August 8, 2018.  Back-tested information may reflect the application of the index methodology with the benefit of hindsight.  Charts above may be partly comprised of historical performance illustration based on a back-test.  S&P 500 TR information was sourced from Zephyr.  Comparison information is for informational purposes only, constituent and weighting metrics can and will be different from the comparison index.  The following companies are not affiliated, Carroll Financial, Solactive AG, S&P 500, Informa/Zephyr.  Adaptive Wealth Strategies is an investment division of Carroll Financial Associates Inc.