Look, here’s the thing: you’re Goldman and you like to chat with clients.
Just to feel ’em out and kind of get an idea of how gullible they are on any given week.
That’s part of trading against them. I mean, it’s hard to fuck people over if you don’t know what they’re thinking.
So you have conversations, figure out where they’re zagging and then zig.
It’s a great way to make money.
Sure, once in a blue moon it doesn’t work out well. Like that time a one-eyed doctor who you suspected was mildly retarded came in and asked you to build him some bespoke MBS tranches to bet against. You thought those premium payments were free money. And then the housing market collapsed.
Oh well – fuck it. Now you know to be suspicious of one-eyed doctors with Aspergers asking you to sell hundreds of millions in protection on mortgage bonds. Lesson learned.
On Friday evenings, you (Goldman) send out a note to clients with a subheader that reads “conversations we are having with clients.” So basically, you’re sending out a note called “conversations we just had with you.”
It’s kind of patronizing, but it’s a lot of fun.
This week, what you talked to clients about was risk-adjusted returns. You’re not sure people are “focused on the right objective.” Specifically, you think maybe people are being a little myopic about minimizing realized vol. “What,” you want to know, “is the cost of pursuing” low vol. without regard for anything else?
In short, you think people should “Sharpe”n up – so to speak. And fortunately for clients, you’ve got a basket of stocks you created just for them that can help.
This is particularly salient discussion in the current low vol. regime.
Here’s what you and your clients talked about…
Conversations we are having with clients: High Sharpe Ratio stocks in a low vol market
US equity market volatility remains near its lowest level in the last 50 years. S&P 500 six-month realized vol ranks in the 1st percentile since 1966. The trend of low vol has also been observed across other asset classes (FX, credit, interest rates) and major global equity markets (Europe, Japan).
Looking forward, the current implied volatility term structure suggests that S&P 500 vol from one month through five years in the future will remain below its historical average (see Exhibit 1). S&P 500 3-month and 6-month implied volatility equal 10.0 and 11.9, respectively, compared with average implied vol of 17.6 and 18.3 during the past 15 years.
In a low vol market, we recommend investors focus on our newly rebalanced High Sharpe Ratio basket (GSTHSHRP) to maximize risk-adjusted returns. The basket comprises an equal-weighted, sector-neutral portfolio of the 50 S&P 500 stocks with the highest “prospective Sharpe ratios.” We use consensus expected return and six-month option-implied volatility to calculate a forward-looking Sharpe ratio for each constituent.
Our High Sharpe Ratio basket has a long-term track record of absolute return outperformance versus the S&P 500. Since 1999, the strategy has beaten the S&P 500 in 71% of semi-annual periods and generated an average six-month excess return of 362 bp (roughly 725 bp annually).
High forecast Sharpe ratio stocks have outperformed the S&P 500 on an absolute (12% vs 10%) and risk adjusted basis YTD (2.3 vs. 2.1). The median stock in our rebalanced basket offers almost three times the expected risk-adjusted return of the median S&P 500 company (0.8 vs. 0.3) and trades at a lower P/E (13.1x vs. 18.4x). Consensus expects 21% upside for the median GSTHSHRP firm vs. 6% for the median S&P 500 stock.
None of the five “FAAMG” stocks (Facebook, Amazon, Apple, Microsoft, and Alphabet) are in our rebalanced basket. Both FB and GOOGL have been dropped from GSTHSHRP in the current rebalance. New constituents in the basket include AZO, DFS, DLTR, HPQ, and INTC (see Exhibit 5).
In recent years, investors have enthusiastically embraced minimum realized volatility (min vol) strategies. Assets held by US min vol ETFs have risen to $26 billion from $1 billion during the past five years. The MSCI Min Vol USA ETF (USMV) accounts for nearly half of total min vol fund AUM.
But many investors are focused on the wrong objective. Fund managers should seek to maximize prospective risk-adjusted returns rather than minimize realized volatility. Of course, lowering the volatility of portfolio returns is a desirable goal, but what is the cost of pursuing this strategy?
Since 1999, a minimum realized volatility strategy has generated lower absolute returns than our high prospective Sharpe Ratio basket while posting only slightly higher risk-adjusted returns. A sector-neutral basket of 50 stocks with the lowest 6-month realized vol has trailed GSTHSHRP by a median of 84 bp during rolling 6-month periods since 1999 (roughly 170 bp annually). But min vol has outperformed our High Sharpe Ratio basket by a median of only 0.1 risk-adjusted points (61% hit rate) during the same period.
However, both the absolute and risk-adjusted performance of our High Sharpe Ratio basket compared with a min vol strategy improves significantly during periods of low market volatility (Exhibit 3). Realized vol during the past six months equals 7 and implied vol during the next six months equals 12. The average gap between realized and implied vol has been 2 points since 2000. When 6-month realized vol has been less than or equal to 12, GSTHSHRP has outperformed min vol on an absolute basis during 74% of six-month periods and on a risk-adjusted basis 54% of the periods vs. 48% and 31% when realized vol is greater than 12. In 2017, min vol has lagged GSTHSHRP on an absolute basis by 340 bp (9% vs. 12%) and generated slightly lower risk-adjusted returns (2.2 vs. 2.3).
A high Sharpe Ratio strategy also outperformed the S&P 500 on both an absolute and risk-adjusted basis irrespective of realized volatility. Since 1999, GSTHSHRP had absolute outperformance 65% of rolling six-month periods when vol was below 12 and 70% of the time when vol exceeded 12. Risk-adjusted outperformance was 58% and 68%, respectively.
Large-cap core managers are currently underweight the median stock within our High Sharpe Ratio basket by 2 bp vs. the S&P 500. T and INTC are most underweight by 62 bp and 24 bp, respectively. Our GSTHSHRP basket has delivered higher risk-adjusted returns than 74% of large-cap core managers YTD (90th percentile in absolute returns). Since 1999, our Sharpe Ratio basket has an information ratio (active return/active risk) greater than 90% of large-cap core mutual funds (Exhibit 4).
We expect our High Sharpe Ratio basket will outperform both Min Vol and S&P 500 on an absolute and risk-adjusted basis during 2H if a low vol regime persists as is predicted by the term structure. A sustained rise in volatility represents a risk to our forecast given min vol has historically outpaced S&P 500 and GSTHSHRP when 6-month vol rises above 12.