Demystifying minimum volatility

• Given the challenging market environment we’ve had in 2022 – many investors have turned to minimum volatility strategies.
• There are many reasons to favor min vol today, but there are also reasons to consider having a strategic allocation to min vol over time.
• The evidence shows that investing in min vol today and over the long-term can be compelling¹

With the return of volatility in 2022, it’s probably not surprising that minimum volatility strategies are back in vogue. Equity markets were down about 20% through the first half of the year. Bonds, historically a diversifier to stocks, were down over 10%². Some investors pivoted their portfolios towards min vol ETFs to help reduce risk in their equity allocations – especially during the second quarter when risk spiked. The iShares minimum volatility suite had more than $2.5 billion of inflows in the second quarter alone³ as investors searched for ways to lessen the pain.

There are many reasons for investors to consider min vol in today’s market – spikes of volatility due to high inflation, the conflict between Russia and Ukraine, a sharp increase in energy prices, concerns over central banks’ action – to name a few. But I am hearing several questions about whether the time is still right for min vol. Not only may the time be right in this moment, we believe there is also a case for a long-term strategic allocation to minimum volatility. Let me explore below in my answers to three common questions about min vol strategies.

From the end of 2021, through the first half of 2022, the yield on 10-year US Treasuries doubled from 1.5% to 3.0%⁴. During that same time frame, the MSCI USA Minimum Volatility Index outperformed the S&P 500 Index by 7.4%⁵.

Our minimum volatility ETFs are equity strategies. Like bonds, interest rates can have an impact on performance, particularly as min vol strategies often invest in rate-sensitive sectors like utilities. That said, rising rates – traditionally a signal for underperformance in bonds – does not necessarily imply a decrease in prices for equity-based min vol strategies. The market price of a stock is driven by the underlying economics of the company, the market it serves, and the needs of its investors.

One characteristic that is reasonably persistent for a company is volatility. Meaning today’s volatility can provide insight into how risky a company might be tomorrow. One need many investors have is managing the risk of their portfolio. Sometimes investors choose different asset classes to help manage risk. That can certainly work but may not be right for all circumstances. Being able to reduce portfolio volatility with stocks can be especially appealing when bonds face the structural headwinds of rising interest rates.

Minimum volatility strategies have historically tended to trade at a premium. Not surprisingly, investors have been willing to pay a higher price for less volatility. We have historically seen the MSCI USA Minimum Volatility Index trade at a 10% premium over the S&P 500 Index, on average, over the last 10 years⁶. Despite the strong relative outperformance in the first half of 2022, min vol is still priced only slightly above its trailing 10-year average at current valuations compared to the S&P 500 Index⁷.

Nevertheless, even if we should see min vol continue to rally, relative valuations have never prevented minimum volatility from reducing risk. As the chart below illustrates, min vol has historically had lower risk than the S&P 500, even during periods when min vol traded above its average premium.

Valuations have varied throughout time. What hasn’t changed – min vol’s ability to lower risk.

Trying to time the market is extremely hard and can be costly. Staying fully invested may be prudent. But what happens if we see markets sustain July’s rally, the S&P 500’s best month since November 2020? Will minimum volatility be left in the dust?

This is where the “how” you capture min vol really matters. Investors may believe that if they just buy stocks in “lower risk” sectors like utilities or consumer staples, they are getting access to the min vol factor. But investors that overweight sectors that seem like safe havens may get left behind when markets rally.

The iShares MSCI USA Min Vol Factor ETF (USMV), which seeks to track the MSCI USA Minimum Volatility Index, uses sector guardrails as part of the underlying index methodology. By capping sectors at +/- 5% of the broad market⁸, USMV can potentially provide diversified access across all sectors to capture a potential upswing – and not diluted exposure to a few “safer” sectors.

The sector guardrails play an important role in helping the strategy capture more of a rally than what may be expected if the underlying index was built without sector caps. When looking at risk-adjusted returns, we can use the Sharpe Ratio⁹ to compare how much return a portfolio/investment provides for a given level of risk.

Over the last decade, as measured by the Sharpe Ratio, the MSCI USA Min Vol Index had higher returns per unit of risk compared to the consumer staples and utilities sectors, as well as the S&P 500 Index¹⁰.

Many investors have turned to minimum volatility strategies this year to help manage risk in their portfolios today. But we believe there is also a case for a long-term strategic allocation to minimum volatility. Rising rates, valuations, and the potential for a strong equity rally may not be reasons to avoid min vol today or over time. If anything, this year is a great reminder of the benefits of having a strategic allocation to minimum volatility strategies.