Our research suggests that the value advantage can be exploited while reducing volatility in a deep value portfolio. We now utilize volatility as an input to our long established investment process.
Given the enormous market dislocations of the 2007/08 period, many market participants have contemplated ways to reduce volatility in their portfolios. Volatility, however, has always been useful to the value investor, and is one of the reasons the cheapest quintile of stocks has produced excess returns over the long term - the "value advantage." So we have undertaken a study to explore the impact of volatility in a deep value portfolio and have observed that moderate volatility is good for the value investor, but extreme volatility can actually detract from performance. In fact, our study showed that performance can be improved, and volatility reduced, when the most volatile stocks are removed from the portfolio.
The "cost" in terms of lost investment performance to reduce the monthly volatility of portfolios is absurdly high. A deep value strategy adds 350 to 400 basis points of return annually in spite of the higher volatility. As the holding period lengthens, the differences in the variability of investment performance amongst the alternatives narrows dramatically:
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Given the enormous market dislocations of the 2007/08 period, many market participants have contemplated ways to reduce volatility in their portfolios. Volatility, however, has always been useful to the value investor, and is one of the reasons the cheapest quintile of stocks has produced excess returns over the long term - the "value advantage." So we have undertaken a study to explore the impact of volatility in a deep value portfolio and have observed that moderate volatility is good for the value investor, but extreme volatility can actually detract from performance. In fact, our study showed that performance can be improved, and volatility reduced, when the most volatile stocks are removed from the portfolio.
Discussion
The academic record documenting the value advantage is extensive and impressive. Value strategies outperform the market on a compound return basis in spite of higher volatility:The "cost" in terms of lost investment performance to reduce the monthly volatility of portfolios is absurdly high. A deep value strategy adds 350 to 400 basis points of return annually in spite of the higher volatility. As the holding period lengthens, the differences in the variability of investment performance amongst the alternatives narrows dramatically:
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