Exploring the Conservative Formula: A Multi-Factor Investment Strategy
Investing is often marked by the quest for strategies that are both robust and diversified. Single-factor strategies, while effective in certain scenarios, may underperform in others, leading to a growing interest in multi-factor approaches. One such strategy, *The Conservative Formula*, developed by Pim van Vliet and David Blitz, offers a unique blend of low volatility, value, and momentum factors. This blog explores the rationale behind the formula and its practical application, drawing from the insights of academic research and its relevance to markets like India.
The Foundations of the Conservative Formula
The Conservative Formula capitalizes on three primary investment factors:
1. Low Volatility Effect:
Traditional finance teaches us that higher risk should equate to higher returns, as outlined by the Capital Asset Pricing Model (CAPM). However, research shows the opposite in many cases — low-volatility stocks often outperform their high-volatility counterparts. This anomaly, termed the “low volatility effect,” stems from investor biases. Investors are drawn to “lottery-like” high-beta stocks with the allure of massive gains, often undervaluing the steady performers.
2. Value Factor via Net Payout Yield:
The formula employs net payout yield (dividend yield + share buybacks) as a measure of value. This metric adapts to different market cycles, providing exposure to both value and quality factors, which ensures a dynamic valuation framework.
3. Momentum Factor:
Stocks that have performed well in the past tend to continue their performance, creating a momentum effect. By integrating momentum, the formula mitigates the risks of value traps — stocks that appear undervalued but fail to recover.
How the Strategy Works
The strategy begins by filtering the largest 1,000 stocks into two groups based on historical volatility over three years. The 500 lowest-volatility stocks are then ranked based on net payout yield and momentum. The top 100 stocks from this refined list form the portfolio, which is equally weighted and rebalanced quarterly. This simple yet robust process ensures consistent exposure to the chosen factors.
Why the Conservative Formula Stands Out
- Diversification with Negative Correlation: Value and momentum are often negatively correlated, which enhances diversification within the portfolio. The inclusion of low-volatility stocks further stabilizes returns, creating a smoother investment journey.
- Consistency Across Markets: The formula has shown remarkable consistency in outperforming benchmarks across global markets, including the U.S., Europe, Japan, and emerging markets.
- Adaptability in Indian Markets: In a study co-authored with Rajendra Raju, it was discovered that the Conservative Formula performs well in the Indian market, making it a viable strategy for domestic investors.
Practical Enhancements and Applications
While the original formula relies on a quarterly rebalancing schedule, tactical adjustments can enhance performance. For example, during sudden market disruptions like COVID-19, implementing intra-quarter risk mitigation strategies can reduce drawdowns. Additionally, incorporating cash management mechanisms can further optimize portfolio performance without deviating from systematic principles.
The Future of Multi-Factor Investing
As investment strategies evolve, there is potential to refine execution further. Drawing inspiration from pioneers like Dimensional Fund Advisors, factors like momentum can be used tactically within value-oriented frameworks. For instance, excluding value stocks without momentum or holding growth stocks with momentum provides additional flexibility.
Conclusion
The Conservative Formula exemplifies how academic research can translate into actionable investment strategies. Its blend of low volatility, value, and momentum creates a balanced approach that mitigates risks while capturing opportunities. Whether you’re a professional investor or a DIY enthusiast, this strategy offers a compelling solution for building resilient, long-term portfolios. For Indian investors, its adaptability further underscores its relevance, bridging global insights with local applications.
Useful resources:
Paper on Conservative Investing
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3145152
Long Only Factor Portfolios In India:
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4000418
Mind Money Matters Authored by Anish Teli:
https://www.amazon.in/Mind-Money-Matters-Anish-Teli/dp/9391317804
Watch the full video on youtube here: https://youtu.be/rX0cc6rtWAY
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Disclaimer: We are not SEBI registered advisors. Any content shared on or through our digital media channels is for information and education purposes only and should not be treated as investment or trading advice. Please do your own analysis or take independent professional financial advice before making any investments based on your own personal circumstances. Investment in securities is subject to market risks; please carry out your due diligence before investing. And last but not least, past performance is not indicative of future returns.
