Posted on 03/04/2013
In last week's report we began a discussion about the Small Cap Equity space, specifically looking at a way of gaining Small Cap Equity exposure by combining high relative strength stocks with low volatility. This is a concept that we have discussed in this report before, and how combing a high relative strength (momentum) index with a low volatility index has produced superior returns over time with lower overall volatility. Both the (DWAS) and (XSLV) are up more than 200% since the end of 2000 (including past index data as well as live ETF trading); however, 50 / 50 combination of DWAS and XSLV resulted in slightly higher returns (212% versus 203% for DWA and XSLV), and did so with much lower volatility than the Russell 2000 Index. The main reason for this phenomenon is a result of how the excess returns of each strategy, DWAS and XSLV, correlate.
In the table below you can see the quarterly excess returns of the DWAS (High RS) and the XSLV (Low Volatility) versus the Russell 2000 Index (RUT). The red bars for the DWAS represent excess returns for the DWAS versus the RUT while the green bars represent excess returns for the XSLV versus the RUT. At the end of the day the correlation of the excess returns of DWAS and XSLV is 0.13, which is to say that DWAS and XSLV are nearly perfectly non-correlated. The benefit of combining two strategies that provide excess returns with very low correlation is that while one strategy might experience a quarter or two of underperformance the other strategy is there to carry the baton. High relative strength stocks and low volatility stocks both outperform; however, they outperform at different times for different reasons.