The promise only few can keep
The low volatility premium has grabbed everyone's attention. Staying flat when markets fell almost 10% this year, the strategy also recorded double-digit returns in 2015. But can it keep its promise of lower risk and superior risk-adjusted returns?
In today’s markets, to many investors, the combination of lower risk and superior risk-adjusted returns sounds like a match made in heaven. It therefore comes as no surprise that they've welcomed a proliferation of low volatility strategies with open arms.
Many of them look at it as a new ‘free lunch’ in the world of investing - something that is increasingly difficult to come by in today’s markets.
It may sound too good to be true. But is it?
First, that ‘free lunch’ is hardly free. Using MSCI's global minimum volatility index as an example, between 1994 and the summer of 2008, it traded at a 10% discount to its market-cap equivalent.
In contrast, since late 2010, when investors were still assessing damages caused by the global financial crisis, the same index has been trading at an average of a 10% premium over last five years. That essentially means that investors are now willing to pay more for every dollar of earnings that these companies generate in the hope that they will offer them protection at times of another downturn.
So is it worth it?
We put to the test two MSCI index strategies that appear to be targeting the famous low volatility premium and promise to deliver superior performance at lower risk: Volatility-tilted index and Minimum Volatility
Volatility-tilted index - considers the volatility of stocks so that more volatile and market-sensitive stocks will have a lower weight, giving way to more defensive names.
Minimum volatility index considers both the volatilities of stocks and the way individual stocks co-behave over time. By constructing a portfolio of uncorrelated stocks they're aiming to make the overall risk of the index can be as low as possible.
Our analysis shows that although the volatility-tilt index provides superior long-term risk-adjusted returns, that advantage disappears once we control for, what we call, the ‘defensive’ factor - the excess return of defensive sectors over cyclicals. In other words, that same excess return could have been simply picked up by the strategy overweighting sectors like healthcare and utilities, without going through all the trouble of weighting individual stocks by the inverse of their historical standard deviations.
And what about the minimum volatility strategy? This one actually holds up better and is not simply a bet in favour of defensives. It seems that the way the stocks are weighted in the optimisation algorithm provides investors with that ‘alpha’ even when controlling for market and ‘defensive’ factors.
This trick is really efficient diversification but that idea is hardly new; in fact it has been around since 1950s. Any minimum volatility strategy needs to move beyond simple volatilities and consider cross-asset correlations as well. Only then it can keep its promise to protect your portfolio in down markets as it did in August and September last year and January this year (see chart below with months of negative market performance highlighted).
Harry Markowitz, soon to turn 90, is likely to celebrate his birthday with the peace of mind that his portfolio theory quantifying the diversification benefit is still the only ‘free lunch’ out there for investors to enjoy.