ANDREW’S ANGLE

Minimum volatility we’ve been here before

Apr 16, 2021

After a year like no other, the first three months of 2021 already provided reasons to be optimistic. Vaccines have been approved and distributed, which has led to continued market gains and a large comeback in stocks that were beaten down in 2020—especially value and small size stocks. Exactly a year after the broad market drawdown on March 24th 2020, equity markets rallied 76.8%.1 Not surprisingly during this time of risk-on returns, we’ve seen Minimum Volatility strategies that seek to mitigate risk trail their broader benchmarks—with some investors now having doubts about the utility of Minimum Volatility. 

What’s the benefit of a slow and steady approach in a rapidly rising market environment? This is not the first time Minimum Volatility has underperformed broader indices during strong rallies. Let’s review Minimum Volatility from a historical context, see where similar performance results occurred, and highlight key reasons that underscore the importance of staying invested in Minimum Volatility through such periods.

The distant past

Extreme market environments come and go. 

In a paper I wrote in 2006,2 I found that stocks with high volatilities had low returns over long sample periods while stocks with low volatilities had returns that were approximately the same as the market. Updating these results to 2021, the pattern still holds.3 Sorting stocks into 10 groups from the lowest volatility group of stocks (group1) to the highest volatility (group 10), average returns are noticeably flat for all groups except the most volatile stocks (groups 9 and 10) where average returns fall dramatically. But, by construction, the volatilities of these stocks increase—this causes Sharpe ratios (a measure of risk-adjusted returns4) of high volatility stocks to be lower than Sharpe ratios of low volatility stocks. A minimum volatility portfolio takes advantage of this effect and tends to hold more low volatility stocks, along with stocks that have low correlations to provide maximum diversifying potential. 

Risk and Return of U.S. Stocks from July 1963 - Feb 2021 sorted by volatility (measured by standard deviation)

The distant past

Source: BlackRock, Fama French data library. Idiosyncratic (residual) volatility data since July 1960 to Feb 2021, using data from https://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html

What is the economic rationale behind the minimum volatility factor? One explanation is that certain large institutional investors have high target returns, which they can only meet if they overweight stocks with high risk. This implies they underweight stocks with low risk, driving up their risk-adjusted returns. The high returns per unit of risk of lower volatility stocks is driven by their lower risk, but they have market-like returns over the long run.

The recent past

Since the inception of our Minimum Volatility strategies in 2011, we have seen expansionary environments where Min Vol tends to lag, as well as slowdowns where Min Vol tends to outperform.

For example, our factor rotation model pointed towards an expansion in each month of 2013. This was the same year where U.S. equities (measured by S&P 500 index’s total returns) were up +32% - the strongest calendar year rally of the last decade. Against this backdrop, the MSCI USA Minimum Volatility index underperformed the U.S. equity market by 7.1% in total returns. Fast forward to 2016 and 2017. Once again, U.S. equities rallied +12% and +22% respectively, while the MSCI USA Minimum Volatility index underperformed by 1.3% and 2.7% for each of those years.

In each year the MSCI USA Minimum Volatility index underperformed, it was primarily driven by a strong risk on rally that benefitted the broader market, driven by companies
that were more volatile and riskier. As John F. Kennedy said in a 1963 speech, “A rising tide lifts all boats.” Each time the MSCI USA Minimum Volatility index has historically underperformed, it has gained back its footing to reach more positive valuations –lower volatility strategies have similarlong run returns as the market over market cycles, but with lower volatility. In fact today, valuations for the MSCI USA Minimum Volatility index is below its long-run historical average as seen in the chart below

The recent underperformance of Minimum Volatility is cyclical, not structural.

P/E premium/discount of Min Vol (represented by MSCI USA Minimum Volatility index) vs S&P 500 index

The recent past

Source: BlackRock, Morningstar. Chart above uses Morningstar’s monthly P/E data from 10/31/2011-2/28/2021. The MSCI USA Minimum Volatility Index incepted 6/2/2008. 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 Fund performance. For actual fund performance, please visit www.iShares.com or www.blackrock.com.

The recent past

Source: Calendar year returns since Jan 2011-Dec 2020 computed as of the most recent month-end using monthly total returns since inception. Min Vol represented by MSCI USA Minimum Volatility index and US equities represented by S&P 500 index.

The present

We are by many measures in an era of exuberance: retail trading is on the rise, market valuations are high, and media headlines are bullish. Times like these is when people pay less attention to risk management – but it is the time when we need it the most. 

Risk management becomes even more important after strong equity market rallies

Careful investors have been keeping their eye on risk. And while I am cautiously optimistic, there is plenty of risk out there today – to name a few:

  • Macro risk impacting the path to reach herd immunity smoothly due to vaccine distribution blocks and the spread of Covid-19 variants
  • Stock-specific risk due to the concentration of U.S. equity markets being at an all-time-high since the 1970s5
  • Risk of markets mean-reverting

Volatility reduction of Minimum Volatility strategies

The present

Source: Morningstar, as of 2/28/2021. Risk (standard deviation) computed as of the most recent month-end using monthly total returns since inception. Tickers denote the following Funds (inception dates included after the name): USMV: iShares MSCI Min Vol USA ETF (10/18/2011); SMMV: iShares MSCI Min Vol USA Sm-Cap ETF (9/7/2016); EFAV: iShares MSCI Min Vol EAFE ETF (10/18/2011); EEMV: iShares MSCI Min Vol EM ETF (10/18/2011); ACWV: iShares MSCI Global Min Vol Factor ETF (10/18/2011). Comparison is with each ETF’s related broad market index.

Since 2011, Minimum Volatility strategies have demonstrated their ability to reduce risk in portfolios (as measured by standard deviation), as illustrated in Figure 3 above. Their risk reduction capabilities have been compelling beyond the U.S. large cap equity market, including across U.S. small caps, developed markets, emerging markets and global equities. 

The future

Whether it was 2013, 2016, 2020, or over decades from the 1960s to the 2020s, all asset returns, including factors like minimum volatility, are cyclical. So while we are in a historic rally, the simple rules of investing apply more than ever.

1. The context of a full market cycle 

Since the inception of Minimum Volatility strategies, we have seen expansionary periods on nine occasions lasting seven months on average.6 The current expansionary regime has now crossed nine months, and while there is further room to run—and during these expansionary environments Minimum Volatility is known to underperform—when there is a downturn, defensive strategies like Minimum Volatility and Quality have tended to shine. Just one year ago during the Covid-19 drawdown in the first quarter of 2020, MSCI USA Minimum Volatility index outperformed the S&P 500 index by +2.5%.

2. Managing portfolio risk 

Minimum Volatility has distinctly reduced volatility in portfolios. In the U.S. equity market, USMV has delivered 18% lower risk than the S&P 500 index since its inception.7 This has allowed investors to free up their risk budgets for other strategies where they would like to own more risk for potentially greater returns. The concentration risk seen from mega cap companies today is further reduced as USMV has 4.4% exposure to the top 10 names of the S&P 500 index.8

3. Stay invested

Loss aversion is the term given to the phenomenon where individuals tend to experience the pain of losses more severely than the joys of gains. This often leads to investors doing the wrong things at the wrong time, including selling right at the wrong time after market downturns. Minimum Volatility strategies can help investors to stay invested in markets by seeking to minimize equity risk, while providing equity market exposure.

It’s crucial to remember, it’s not about timing markets, but time in the market with Minimum Volatility.

Andrew Ang
Andrew Ang
Head of Factor Investing Strategies
Andrew Ang, PhD, Managing Director, coordinates BlackRock’s efforts in factor investing. He leads BlackRock’s Factor-Based Strategies Group which manages macro and style ...
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