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Aon Retirement and Investment Blog

Minimum volatility – in a sweet spot, but for how long?

In a peer universe of over 450 Global All-Cap Equity funds, of the top 25 performers over the last year, around half contained “Low Volatility," "Managed Volatility,” or “Minimum Variance” in the strategy name (Source: eVestment, 1 year to June 2016).
A chart (in US$) of the MSCI Minimum Volatility Index ("Min Vol") (blue) and the MSCI World ("World") (red) below shows quarterly returns for the last seven years. In the six quarters when the market fell, the Min Vol Index outperformed, as you would expect. In the other 22 quarters when the market rose, the index underperformed World in 15 of them, but did better than a rising market in seven quarters, five of which are since March 2014. This isn't really meant to happen – what could be the possible reasons?

Source: eVestment, Aon Hewitt.
One factor is that interest rates have stayed low for so long, and expectations for future rises have abated. The correlation of the excess return of the MSCI Minimum Volatility Index against MSCI World, measured against the returns on US Treasuries has been consistently positive (contrasted with the low to negative correlation of outperformance of the  MSCI Value index with a strong bond market below), suggesting the minimum volatility style has benefited from the bull market in bonds. Intuitively this seems right, with "bond proxies" populating significant parts of minimum volatility portfolios.

Source: eVestment, Aon Hewitt. Excess return measured against MSCI World.

Concerns that economies will stay in the doldrums have weakened the case for economically sensitive, cyclical stocks (which tend to be volatile), and favoured sectors of the market which have predictable sales and profit growth (such as Consumer Staples), or are reassuringly dull (such as Telecommunications and Utilities). These three sectors comprised 34% of the MSCI World Minimum Volatility* index at the end of June 2016, compared to 19% of the MSCI World Index. Cyclical companies which suffer in a regime of lower-for-longer interest rates (implying more sluggish growth than previously expected), like Financials and Consumer Discretionary stocks, are a larger proportion of the MSCI World index, and these areas have been the laggards over the last year. In addition, lower-for-longer interest rates have driven investors to search for yield given the very low returns available on bonds, further favouring those equity sectors paying higher dividends (e.g, Telecommunications and Utilities).
However, some amber lights are flashing. The valuation of these stocks has been rising gradually over time. At the end of June 2016, the forward Price to Earnings (P/E) ratio of the widely followed MSCI Minimum Volatility index was 19.3x, a 23% premium to the market, and the Price to Book (P/B) ratio stood at a 37% premium relative to the MSCI World Index.

Source: Datastream

Valuations matter – eventually. Any unexpected downgrades in earnings forecasts for these stable companies (or perhaps more likely a relative improvement elsewhere) could cause share prices to weaken and volatility to increase. It is noticeable that some actively managed minimum variance strategies have started to filter out the more expensive low volatility stocks in their universe, reasoning that high valuations can potentially be an indicator of future volatility, and therefore undesirable. Funds which track the passive Minimum Volatility indices cannot make this judgement, as they have to wait for changes in volatility (measured historically) to trigger an index rebalancing on the pre-determined dates (in the case of MSCI, May and November).
Another sign of a mature bull market is one which attracts large inflows from more tactical investors. Minimum Volatility Exchange Traded Funds focused on the US equity market have attracted multi-billion dollar inflows this year, and the largest has almost $15 billion in AUM (Source: BlackRock, end June 2016), putting it in the top 50 by size across all ETFs. Whilst some of this will be long-term money, it is likely that some is hot money chasing recent performance, and likely prone to exit at the first sign of trouble.
Whilst we believe that the low volatility approach should produce good risk-adjusted returns over the longer term, investors should remember that the strategy's primary objective should be to reduce equity volatility, not generate outsized performance in both good markets and bad. Given recent robust performance even in strong markets, that reminder may prove to be a timely one.

Further reading on Aon Hewitt's views on low volatility equity investing can be found here.
* The index is calculated by optimizing the MSCI World Index, its parent index, for the lowest absolute risk (within a given set of constraints, such as turnover limits, and sector and country limits).

Phil True is an equity specialist in Aon Hewitt’s Global Investment Manager research team in London

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