Last month, I wrote about the expanding equity index universe and the case for investing in frontier markets. Another equity index development that is gaining traction with investors is low- or minimum-volatility indexes. Some early adopters have expanded their own equity investment space and enhanced their equity portfolios’ risk-adjusted returns by utilizing low-volatility index strategies.
Minimum-volatility index strategies, which cover both developed and emerging markets, attempt to deliver lower volatility than their purely cap-weighted peers. It’s this prospect of reducing equity risk without sacrificing return that’s eliciting a great deal of interest from institutional investors—one of the great unsung success stories of 2012 and likely to be one of the important trends for index investors around the globe in 2013 and beyond.
Although the capital asset pricing model (CAPM) suggests that a portfolio with a lower market beta must logically have a lower expected return, empirically, the reverse has proven true over many decades of investment returns. Over the long term, minimum volatility indexes have exhibited both lower risk and higher returns relative to their cap-weighted counterparts. And despite the fact that this anomaly is well known and has been widely researched, it continues to persist.
Deconstructing the anomaly
A number of factors help to shed some light on the greater-than-expected returns exhibited by low-volatility portfolios, including the behavioural tendencies of both individual and institutional investors.
While individual investors often overpay for highly volatile stocks in their quest for higher returns, institutional investors find it difficult and expensive to establish shorts in many of these stocks, as they tend to be small and illiquid. Meanwhile, many active managers are drawn to high-volatility securities—and neglect lower-volatility ones—as they attempt to outperform their benchmarks.
As a whole, the market tends to drive up the price and reduce the expected return of high-volatility securities relative to their lower-volatility peers.
Finding a place in the portfolio
Given the empirical performance history, coupled with investors’ recent painful memories of large drawdowns in equity portfolios during both the global financial crisis and the bursting of the dot-com bubble, minimum-volatility strategies appear to be a compelling vehicle for reducing equity risk.
These strategies have proved particularly valuable during bear markets, exhibiting substantially lower peak-to-trough drawdowns, and have actually outperformed cap-weighted indexes over long periods encompassing both bull and bear markets.
Investors are finding some interesting ways of incorporating allocations to minimum-volatility strategies into their equity plan. For the growing number of institutions that use risk budgets, for example, an allocation to minimum-volatility strategies can free up some of that budget to pursue excess returns elsewhere. And for liability-driven investors or other plans seeking to de-risk, the strategies may provide a means to reduce equity risk without significantly lowering expected returns.
Few might have predicted that quantitatively designed, volatility-dampening indexes would find a place alongside traditional cap-weighted benchmarks.
While it may be equally difficult to foresee what the future holds (a minimum-volatility frontier markets index, perhaps?), one thing seems clear: investors would be well served to keep abreast of the latest developments, as the inexorable march of the beta universe carries on.