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What matters more – making money or not losing it?

BlackRock |Dec 12, 2019

Redefining your lens on risk may help you win more by losing less

What does the word “risk” mean to you? In asset management, risk is commonly defined as standard deviation, or how much an investment’s returns vary from its mean return. However, I often find clients don’t think of risk in those terms, making some conversations difficult. Instead, many investors equate risk simply with losing money. The question then becomes: “Is there an alternative measure that can help clients better understand and therefore more appropriately manage risk?” One such measure is upside/downside capture.

Redefining risk

The concept of upside/downside capture is fairly simple. “Upside” is defined as periods when the market earned positive returns, while “downside” refers to periods when the market earned negative returns. “Capture” indicates how much an investment participated in the market return. All else equal, it is considered desirable to capture more than 100% of the market’s upside (increase more), and less than 100% of the downside (decline less).

One strategy that has been appealing when it comes to capturing less market downside is minimum volatility1. Minimum volatility is designed to reduce risk, while maintaining 100% equity exposure. Why is this important? Humans tend to experience the pain of losses more than the joys of equivalent gains, a bias known as “loss aversion.” Loss aversion is one reason many investors closely identify risk with losing money, rather than its true definition of standard deviation. This bias can result in impulsive (and likely bad) decisions when the value of their portfolio decreases. For example, due to fear of loss, many investors pulled their money out of the market in the fourth-quarter turmoil of 2018 only then to miss the market rally in early 2019. Minimum volatility strategies may help prevent these negative impulsive investor actions by reducing risk in a manner that resonates with investors -- encouraging them to stay invested in periods of market stress and helping to keep them on track toward their long-term financial goals.

Understanding winning by losing less

When we say that US minimum volatility has captured 80% of the upside of the S&P 500 but only 59% of the downside, many investors assume that means the strategy has lagged but with lower risk. Yet, since its inception in 2008, minimum volatility has outperformed the S&P 500 by 2% annualized2.

How can a strategy that captures less upside outperform over the long term? The answer is simple - minimum volatility has been able to historically deliver superior returns by declining less during market drawdowns. Said differently, the strategy has won by losing less.

Let’s use 2019 as an example. Through September of this year, minimum volatility is up 24.1% while the S&P 500 is up 20.6%3. How can this be?

Growth of $100 for the MSCI USA Minimum Volatility Index and S&P 500 Index
January 2019 – September 2019

Growth of $100 for the MSCI USA Minimum Volatility Index and S&P 500 Index

Source: Morningstar Direct. Data from 12/31/2018-09/30/2019. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results. Index performance does not represent actual iShares Fund performance. For actual fund performance, please visit www.iShares.com or www.blackrock.com.

Despite a positively trending market for most of the year, US Large cap stocks4 have experienced moments of significant weakness where minimum volatility has outperformed. In May, the S&P 500 declined -6.4% while minimum volatility declined only -1.6%. In August, the S&P 500 declined -1.6% and minimum volatility gained 1.7%5. Losing less in 2019, minimum volatility returns have compounded to better returns in aggregate over the year. This idea of winning by losing less translates into the longer-term results of minimum volatility as well. In fact, by capturing the lion’s share of the upside but significantly mitigating the downside, minimum volatility has historically been able to beat the market’s return since inception, while also delivering on risk reduction.

Since Inception Summary Statistics
June 2008 – September 2019

IndexReturnStandard DeviationUp CaptureDown Capture
MSCI USA Minimum Volatility Index 11% 12% 80% 59%
S&P 500 Index 9% 15% 100% 100%

Source: Morningstar Direct. Monthly observations from 6/2/2008 – 09/30/2019. Inception date of the MSCI USA Minimum Volatility Index is June 2, 2008. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results. Index performance does not represent actual iShares Fund performance. For actual fund performance, please visit www.iShares.com or www.blackrock.com.

A map for navigating uncertainty

In today’s uncertain environment there is no shortage of ways investors can lose money. Strategies that focus on limiting volatility can add resilience, while offering investors the comfort to stay invested in the market through all environments. Think of upside/downside capture as one way to provide clarity on the road to pursuing long-term investment objectives.

Holly Framsted, CFA
Head of US Factor ETFs within BlackRock’s ETF and Index Investment Group