As we covered in our previous blog post, minimum volatility indexes are notably more complex than cap-weighted, or even many common style indexes. But they are still designed to be straightforward entry points into less volatile equities that encourage the development of ETFs and other vehicles intended to track the indexes’ performance at relatively low fees. Towards this end, their construction employs a number of rules and constraints (as we detailed earlier) to ensure they’re feasible in this role.
These constraints, however, are compromises that should represent an opportunity for a skilled active manager to improve the risk-return outcome for their clients. We believe there are several dimensions in which an active manager can potentially better a minimum volatility index in a meaningful way, including:
(See our earlier post, 3 Ways to Improve on Defensive Equity Indexes, for a closer look at those.)
Here, however, we’re attempting to solve the problem of the large and highly dynamic tracking error associated with defensive strategies relative to the cap-weighted benchmarks. As such, we will focus on a portion of an equity allocation in which the minimum volatility index is the benchmark, and providing additional return with manageable active-risk expectations.
Greater Portfolio Efficiency Can Provide Alpha
Minimum volatility indexes may have their long-term performance bolstered by a combination of a) better return compounding (lower ‘volatility drag’), b) under-weighting or excluding the highest-volatility stocks in the investable universe, and c) the capture of a rebalancing premium (as they are not buy-and-hold portfolios). Beyond that, they typically outperform in downturns or periods of market turmoil. This is an incidental and episodic source of outperformance, and sometimes only in backtests (index methodologies are sometimes re-tooled following the most significant drawdowns with the benefit of hindsight). In the absence of significant crises, or when market volatility is low, this outperformance may not be counted upon to cover implementation costs. Even during market crises, the turnover required for reliably navigating the market can result in overcrowded or concentrated trades that cost both return and risk reduction.
Happily, much like a traditional active manager can improve performance within a tracking error range against a cap-weighted index, so too an active manager can improve performance within a tracking error range measured against a minimum volatility index. Constraints with the goal of maintaining passive-like replicability and investability still inherently limit these indexes’ positioning away from the cap-weighted index. Relaxing these constraints allows a truly active approach to create a significantly more efficient portfolio.
More timely estimates of the stocks’ individual volatility and correlation relative to each other allow for consistently more diversified positioning. Freedom from the restrictive low-turnover and active constraints allows a much more adaptive and effective positioning and, combined with a more up-to-date and sophisticated rebalancing, unleashes the opportunity to harness the stocks’ individual price movements, or relative volatility (i.e., how they move relative to the total index) as a reliable alpha source. The overall result is to produce consistent excess returns while also managing active risk relative to the minimum volatility index – and, critically, can be achievable while maintaining a similar level of absolute risk as that benchmark at the portfolio level (see below).
How Managing an Active Strategy vs. a Minimum Volatility Benchmark is Different
The characteristics of minimum volatility indexes result in very different active portfolios compared to typical cap-weighted benchmarked portfolios. While minimum volatility indexes are still tied to their parent indexes to some degree via the aforementioned constraints, they represent both a less diverse collection of stocks and a larger exposure to small stocks than cap-weighted indexes.
Further, there is always the possibility that the index providers may substantially adjust their risk models or construction methodologies, especially in the wake of a major crisis, as some did in 2009. Such a change would potentially cause two disruptions: a possible change in the expected behavior of your benchmark, and the associated adjustment required in the active strategy to maintain the manager’s own expected risk-return outcome. In the same vein, if you’re counting on controlled tracking error versus the minimum volatility index as your link to downside protection, that insurance is only as good as that index.
Finally, liquidity can be a concern in indexes with relatively few holdings, and smaller stocks holding larger weights, than their cap-weighted parents. They can be more sensitive to large inflows, particularly during periods of market turmoil, which may increase transaction costs and negate the expected low volatility properties precisely when they’re most desired.
Compare Capital Outcomes
Active management has the potential to add value beyond minimum volatility indexes, but we’ve yet to quantify what that can mean to a plan’s funding status. See for yourself the impact it can have in our latest paper, “How a New Benchmark Adds to Defensive Equity Strategy Evaluation.”
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