Funds behaving badly
Low Volatility, Covered Call strategies fall short
It’s difficult to write about the broad impacts of COVID-19 on financial markets, given the enormous impacts the virus has had on all aspects of our lives. But impacts for specific portfolio and fund mandates are directly quantifiable and therefore might give us some cues for investment tactics moving forward.
Markets all over the world have seen their biggest drawdowns since the Financial Crisis of 2008-09, and it happened very quickly. We have seen a significant bounce back since the March market meltdown, and it’s still quite possible that we have not seen the markets hit bottom yet.
The S&P/TSX Composite Index peaked this year on Feb. 20 at 17,944, and the bottom (so far) was 11,228 about a month later on March 23. That is a 37% drop over just 33 days. The S&P 500 Composite Index touched its high on Feb. 19 at 3,386, bottoming out 32 days later at 2,237 on March 23, a drop of 34%. In contrast, during the Financial Crisis, the S&P 500 dropped 56% over 511 days.
With such massive drawdowns, I wanted to see how some of the new, somewhat conservative equity strategies are holding up. These are the strategies whose objectives are to provide a higher floor during turbulent markets or provide a safety net relative to traditional equity strategies. I am looking specifically at the Low Volatility strategy and the Covered Call strategy, two popular strategies that are relatively new and have not been tested with a significant market correction until now.
Low Volatility funds
The Low Volatility strategy is essentially centred on holding a collection of stocks that typically have lower volatility than their respective market. It’s a strategy dominated by ETFs, but there are some mutual funds using it as well. The strategy can be done with active management, but it is more commonly executed with a rules-based or passive approach.
Let’s start with a prominent low volatility benchmark, the S&P 500 Low Volatility Index, which is tracked by some ETFs. The index measures the performance of the 100 least volatile stocks in the S&P 500, the top 10 constituents of which include eight utilities companies and Walmart Inc. (NYSE: WMT).
As I mentioned earlier, between Feb. 19 and March 23, the S&P 500 dropped 34%. But the S&P 500 Low Volatility Index actually had a worse drawdown, losing 36%. It’s not what you would have expected. There is also an S&P/TSX Composite Low Volatility Index, which lost 38% between Feb. 20 and March 23, again slightly worse than the S&P/TSX Composite Index, which was down 37%.
The Low Volatility investment funds tell a similar story. Over 1-, 3-, and 5-year periods these funds on average have lower standard deviations than their category averages. But of the 15 Low Volatility funds in the Canadian Equity and U.S. Equity categories, 10 had worse drawdowns than their category average between Feb. and March 23.
Some funds had drawdowns that were more than 8% worse than the category average. It’s interesting to note that all Low Volatility funds have produced 3- and 5-year standard deviations that are lower than their category average, but on average, 3-year returns have now dropped below the category average for Emerging Markets, Global Equity, and U.S. Equity funds.
The best-performing Low Volatility fund was the Quadrus U.S. Low Volatility Fund (Putnum), which lost only 12.2% during the market drawdown period. It did, however, benefit from the 8% appreciation of the U.S. dollar versus the Canadian dollar over that period.
Covered Call funds
The Covered Call strategy is executed by holding a stock and selling a call option on that same stock. The goal of the strategy is to collect the income from the sale of the option and benefit from small gains in the stock price. The upside of the strategy is capped because of the option, but the downside is also minimized because of the income from the option sales.
The CBOE S&P 500 BuyWrite Index (BXM) is a passive index based on buying the S&P 500 constituents and selling call options on the index, so it is the best general representation of the covered call strategy for U.S. Equity funds.
The index lost 30.2% between Feb. 19 and March 23, outperforming the S&P 500 by about 4%. The average loss for U.S. Equity funds over that period was 29.5%. There are four covered call funds in the U.S. Equity category, and they all lost more than the category average, while three of them lost more than the S&P 500.
Overall, there are 27 Covered Call funds in Fundata’s database, and 16 of them had drawdowns that were worse than their respective category average, and that is after taking into account the effects of the monthly distributions that were paid. Over a three-year period, the results are mixed, but a slight majority of covered call funds are performing better than their category average.
Overall, the numbers show that the Low Volatility and Covered Call strategies have not performed as expected during a major market correction. When you are looking for a strategy to help hedge some downside risk in your portfolio, the key is to look at how it correlates with the rest of your portfolio during significant market corrections. A conservative or lower-risk fund that performs well during a bull market is great, but if that fund increases your losses during a market correction, it is really not doing what you need it to do.
Reid Baker, CERA, ASA, is Director, Analytics and Data, at Fundata Canada Inc., a leading source for investment fund information, and is Chairman of the Canadian Investment Funds Standards Committee (CIFSC).
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