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What's Dispersion Got to Do with It?

July 23, 2020

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.[1]

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.

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Source: Yahoo Finance. Data from 12/31/94 - 3/31/20. Past performance does not guarantee future results. The referenced indices is discussed for informational purposes only and is not meant to represent the Fund. Investors cannot directly invest in an index. What may explain this outperformance?

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.


[1] Lazzara, Craig, The Defensive Advantage, S&P Dow Jones Indices

Carefully consider the Fund’s investment objectives, risk factors, charges and expenses before investing. This and additional information can be found in the Fund’s prospectus and Summary Prospectus, which may be obtained by visiting https://armoretfs.com/documents. Read the prospectus and Summary Prospectus carefully before investing.

Foreside Fund Services, LLC, distributor.

Investing involves risk, including possible loss of principal. The Fund’s return may not match or achieve a high degree of correlation with the return of the Index. To the extent the Fund’s investments are concentrated in or have significant exposure to a particular issuer, industry or group of industries, or asset class, the Fund may be more vulnerable to adverse events affecting such issuer, industry or group of industries, or asset class than if the Fund’s investments were more broadly diversified. Issuer-specific events, including changes in the financial condition of an issuer, can have a negative impact on the value of the Fund.

A new or smaller fund is subject to the risk that its performance may not represent how the fund is expected to or may perform in the long term. In addition, new funds have limited operating histories for investors to evaluate and new and smaller funds may not attract sufficient assets to achieve investment and trading efficiencies.

Shares are bought and sold at market price (closing price) not net asset value (NAV) and are not individually redeemed from the Fund. Market price returns are based on the midpoint of the bid/ask spread at 4:00pm Eastern Time (when NAV is normally determined) and do not represent the return you would receive if you traded at other times.