What's Dispersion Got to Do with It?
Financial theory posits that stocks with higher risk or volatility should outperform those with lower risk or volatility. However, a report from S&P showed that indices that were designed to provide downside risk mitigation actually outperformed the overall market over the 12/31/94 - 3/31/20 time period, something that they were not designed to do.
The report points to the relationship between returns and dispersion as a possible explanation for the outperformance of portfolio that have downside risk management as a goal.
Outperformance of Protection Strategies The S&P 500 Quality, Dividend Aristocrats, and Low Volatility Indices were designed to provide investors with protection in down markets and participating in rising markets. They are expected to outperform when the market falls and underperform when the market rises.
Yet, as the chart below highlights, between 12/31/94 - 3/31/20, these indices have outperformed the broader S&P 500.
The Relationship Between Dispersion and Returns
Dispersion measures the degree to which the constituents of an index produce similar results. If dispersion is low (high), the performance difference between individual stocks within the index is low (high).
When dispersion is low (high), the impact of deviating from the index is also low (high). Thus, the potential advantage of making active bets in a portfolio, either on a security level or a factor level, is low when dispersion is low and vice-versa. S&P found that dispersion historically has been higher when markets are falling and low when markets are advancing.
Put another way, the potential payoff to active security or factor bets is high when the market is falling and low when the market is advancing.
Making the connection, S&P noted that defensive factors tend to outperform when the payoff for outperforming is high (declining markets with high dispersion) and to underperform when the penalty for underperformance is low (rising markets with low dispersion).
This asymmetric return pattern may help to explain why defensive strategies typically capture more of the market’s upside and less of its downside, and why they have historically outperformed over long periods of time.
The Armor US Equity Index ETF (ARMR) may provide investors with an attractive vehicle for equity market participation in a product designed to manage downside risk.
The Armor US Equity Index ETF (ARMR) The Armor US Equity Index ETF (ARMR) seeks to provide investment returns that, before fees and expenses, correspond generally to the total return performance of the Armor US Equity Index. The index is designed to provide exposure to the sectors of the US equity market that the fund’s index provider believes are most likely to generate positive returns while providing downside protection and experiencing lower volatility relative to the US equity market.
The index which serves as the basis for ARMR uses sector momentum, which looks to invest in sectors that have been experiencing positive performance, in an aim to achieve its goal.
 Lazzara, Craig, The Defensive Advantage, S&P Dow Jones Indices