The case for a min volatility hedge

Russ explains why a rotation into minimum volatility stocks may help protect equity gains.

A few weeks back I highlighted a relatively new challenge in building multi-asset portfolios: In a world of near-zero long-term interest rates, bonds are less effective as a hedge against equity risk. While investors can manage this through a combination of very long duration Treasuries, cash and potentially gold, there are less obvious ways to maintain equity exposure while balancing risk. One solution is to still own stocks, just own more of the less volatile ones, an investment style known as low volatility or minimum volatility.

With global stocks up 45% and equity volatility down 70%, this is a reasonable time to think about protecting gains. In this context, rotating some equity exposure into low volatility strategies may make sense.

Volatility ahead?

Despite soaring earlier in the year, volatility has plunged as equities have rallied. Not surprisingly, less volatile stocks have not participated in the rally to the same extent as their more volatile cousins. Also challenging low volatility strategies: Market gains have been unusually concentrated in a handful of mega-cap growth names. That said, low volatility strategies easily outperformed during March’s volatility. In addition, while trailing the broader market these strategies have done much better than perennially troubled value names (see Chart 1).

MSCI World factor index performance - year to date

MSCI World factor index performance - year to date

Source: Refinitiv DataStream, chart by BlackRock Investment Institute, as of June 30, 2020.
Past performance is no guarantee of future results. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.

There is a strong case for a strategic allocation to low volatility equities. Historically, they have helped manage overall portfolio volatility. In fact, our portfolio construction research suggests an allocation as high as 15% within a traditional 60/40 portfolio. But it is when volatility is rising that low volatility is the most valuable.

Since 2011 a global portfolio of low volatility equities has tended to outperform when volatility, measured by the VIX Index, is rising. Looking at months when the VIX Index is higher, the MSCI All Country World Index (ACWI) of low volatility names outperformed a market cap-based index roughly 70% of the time and by an average margin of 0.70%. And that outperformance tends to rise with volatility. When the VIX increases 30% the average outperformance rises to 1.00%; with a 40% rise, average outperformance is well over 2% per month. That said it should be noted that particularly large spikes, such as in February of 2018 or 2020, can be associated with heightened correlations and most styles going down in tandem.

Pick your poison

Since the March low investors have benefited from taking as much risk as they can tolerate. And while I still believe equities will be higher by year’s end, those gains may come with more volatility.

Here’s why. For starters, we are now entering what is traditionally the weakest season for stocks. Seasonal headwinds are likely to be compounded by ongoing struggles to contain the virus, a quickly deteriorating U.S.-China relationship and/or the 800 lb. gorilla of a unique and potentially market moving election. With bond yields already at historic lows and the dollar less of a safe-haven, investors need to look for other ways to hedge their portfolio. One simple solution: Bake the hedge directly into the equity portion of your portfolio.

Russ Koesterich
Russ Koesterich
Russ Koesterich, CFA, is a Portfolio Manager for BlackRock's Global Allocation Fund and is a regular contributor to The Blog.