No evaluation of defensive equity strategies is complete without an examination of their benchmarks; indeed, why not invest in a passive solution? The Journal of Index Investing spotlights this topic and more in a recent article written by Intech, and here’s a brief summary why we believe active management offers a number of advantages over Minimum Volatility Indexes.
Minimum Volatility Indexes are a straightforward entry point into defensive equity investing. Unfortunately, index providers often constrain their creations to encourage development of ETFs and other vehicles intended to track the indexes’ performance. These constraints, however, are compromises that represent an opportunity for a skilled active manager to improve risk-return outcomes.
We believe there are several dimensions where an active manager can seek to improve on a Minimum Volatility Index in a meaningful way, including:
Greater Portfolio Efficiency Can Provide Alpha
Minimum Volatility Indexes generally seek to bolster their long-term performance by: 1) improving compound returns through lowering “volatility drag,” 2) under-weighting or excluding the highest-volatility stocks, and 3) capturing a rebalancing premium (as they are not buy-and-hold portfolios).
Beyond that, these indexes typically outperform in downturns or periods of market turmoil. This is an incidental and episodic source of outperformance, and sometimes only in backtests (index providers will sometimes retool their methodologies following the most significant drawdowns with the benefit of hindsight).
In the absence of significant crises, or when market volatility is low, investors can’t necessarily count on performance 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 an 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. However, active managers can relax these constraints to target a significantly more efficient portfolio.
First, they can use more timely estimates of the stocks’ individual volatility and correlation relative to each other to unleash more diversification potential. Active managers are also free from turnover restrictions, allowing much more adaptive positioning. Combined with more up-to-date and sophisticated rebalancing, these active management advantages offer the opportunity to harness stocks’ relative volatility 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).
The characteristics of Minimum Volatility Indexes result in very different active portfolios compared to typical cap-weighted benchmarked portfolios. While Minimum Volatility Indexes are linked 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 expected risk-return outcome. In the same vein, if you’re counting on managing 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. Minimum volatility indexes 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 you want those most.
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 The Journal of Index Investing.
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