I came across this blog post from Zhen Wei, Head of China Research at MSCI, discussing whether minimum volatility strategies underperform during periods of rising interest rates. With the recent rise in interest rates in response to cyclical reflation, minimum volatility strategies have come under the spotlight given that many low volatility securities tend to be sensitive to interest rate volatility.
First, for a good summation of the underlying appeal for investing in minimum volatility strategies, I suggest this paper, "Betting Against Correlation: Testing Theories of the Low-Risk Effect," recently published by AQR. The whole point in buying minimum volatility ("MIN_VOL") strategies is to implement MIN_VOL in a 'smarter' fashion as opposed to just reducing your equity allocation to a comparable market risk level. Smarter implementation could mean buying a basket of statistically low volatility stocks (NYSEARCA:SPLV), a low volatility portfolio (NYSEARCA:USMV), or a low volatility portfolio with bells and whistles (NASDAQ:LVHD). Why MIN_VOL is 'smarter' is subject to debate (Is it structural due to the limits of leverage and shorting? Is it behavioral due to the prospects of buying lottery stocks?). Alternatively, investors can take the simpler route by reducing their equity allocation (the S&P 500 as an example) to match the inherent systematic risk (or market beta) of MIN_VOL strategies.
MSCI's blog post claims that MIN_VOL strategies behave more like equities than fixed income, one need not worry about how MIN_VOL performs in a rising rate environment despite its perceived exposure to interest-rate sensitive areas of the market such as utilities. Of course, MIN_VOL strategies will be more sensitive to equity volatility than interest rate volatility because MIN_VOL strategies hold diversified baskets of equities (not bonds) even if those baskets may be concentrated in certain interest rate-sensitive sectors such as utilities.
However, I believe MSCI understates the risk of rising rates on MIN_VOL strategies relative to a cap-weighted index such as the S&P 500 when MSCI asserts that:
"…[MIN_VOL] did not systematically lag the market, even during the rising-rate environment: There were periods of under- and over-performance linked to market volatility. Overall, the strategy was largely in line with the market, returning a negligible -12 bps from 1963 - 1981 (when 10-year U.S. Treasury yield rose by an average of 63 bps per year)."
Granted the author is focused on long time horizon interest rate regimes (rising rates from 1963 to 1981 and declining rates from 1982-2017) when making his assertions. However, the author could have better served his readers if he incorporated a risk model analysis of MIN_VOL to assess interest rate risk as it is reflected in the current portfolio (MSCI owns the BARRA risk model so it wouldn't be an issue to run this analysis). What MIN_VOL investors should care more about is:
What is my interest rate exposure today given the current make-up of the MIN_VOL portfolio? How would today's MIN_VOL portfolio behaved during more recent interest rate spikes?
MIN_VOL Does Underperform the Broader Market During Interest Rate Spikes
When looking at more recent periods of interest rate spikes such as the rebound in cyclical inflation during the 2nd half of 2016 and the taper tantrum of 2013, MIN_VOL (as represented by SPLV and USMV) significantly underperformed the S&P 500 ( Exhibit 1), even when beta-adjusting the S&P's return (using 0.75 beta as an approximation).
Exhibit 1 - MIN_VOL Underperforms the Risk-Adjusted S&P 500 During Two Recent Rising Rate Periods
This underperformance could very well come from other active exposures, the most obvious one is holding less market risk versus the S&P 500, which can help explain its underperformance in the latter half of 2016. But based on these two rising rate episodes, MIN_VOL clearly lagged the broader market even when adjusting for market risk.
Forward-looking risk models and scenario analyses can also confirm MIN_VOL's higher interest rate sensitivity versus a cap-weighted benchmark. Based on these risk profiles, MIN_VOL would be expected to underperform the broader market in rising interest rate periods, all else equal.
Bloomberg's risk model estimates that MIN_VOL has a higher loading to 'yield' versus the S&P 500 (Exhibit 2), although this exposure is partially offset by a positive active exposure to 'profitability' or quality which can behave differently than 'yield' during periods of interest rate volatility. Nevertheless, MIN_VOL strategies reflect a higher sensitivity to 'yield' versus a cap-weighted benchmark; hence, MIN_VOL would be expected to underperform during a spike in interest rates given how closely 'yield' tracks interest rate changes.
Exhibit 2 - MIN_VOL Has Positive Exposure to 'Yield' Factor
Finally, Bloomberg's scenario analysis (Exhibit 3) confirms that the current MIN_VOL strategies would underperform the S&P 500 under a rising interest rate scenario (i.e. 1% increase in rates).
Exhibit 3 - MIN_VOL is Expected to Generate Lower Returns versus the S&P 500 Under Rising Rate Scenarios
MSCI's blog post leads readers to conclude that MIN_VOL strategies would not underperform the broader markets during a rate rise regime, but recent periods of rising rates as well as forward-looking risk analysis would suggest otherwise. If investors in MIN_VOL are concerned about rising rates, they should consider diversifying into more pro-cyclical strategies.
At the time of this writing, 3D Asset Management held SPLV and USMV and did not hold LVHD. The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future. The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy. It is for informational purposes only. The above statistics, data, anecdotes and opinions of others are assumed to be true and accurate; however, 3D Asset Management does not warrant the accuracy of any of these. There is also no assurance that any of the above is all inclusive or complete. Past performance is no guarantee of future results. None of the services offered by 3D Asset Management are insured by the FDIC, and the reader is reminded that all investments contain risk. The opinions offered above are as of March 20, 2017, and are subject to change as influencing factors change. More detail regarding 3D Asset Management, its products, services, personnel, fees and investment methodologies are available in the firm's Form ADV Part 2, which is available upon request by calling (860) 291-1998, option 2, or emailing firstname.lastname@example.org or visiting 3D's website at www.3dadvisor.com.
Disclosure: I am/we are long SPLV AND USMV.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.