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Dimitris Melas

Dimitris Melas
Managing Director and Global Head of Core Equity Research

Brexit shows (again) the benefits of minimum volatility

Brexit brought mayhem to Britain, at least in the short run. Markets fell, the pound dropped, the prime minister resigned and, worst of all, the English national football team was knocked from the European Championship by Iceland!

How did the shock of Brexit affect smart beta strategies and, in particular, the minimum volatility index? Did the index provide relative protection on the downside as it has historically? Is minimum volatility overvalued?

Let’s look at the facts.

 

Minimum volatility has a history of outperformance

Index performance (USD)

 

Relative performance

Source: MSCI Research

 

The charts above show the performance of minimum volatility in the U.S. market over the past 17 years. This period includes a historical backtest from 1999 to 2008 and live performance from 2008 through 2016. Minimum volatility is a rare example of a strategy index where live performance has been as good if not better than the backtest. 

We experienced four episodes of severe market turmoil during this period: the bear market of 2001-2003 that followed the internet bubble, the global financial crisis of 2008, the eurozone crisis that peaked in 2011, and, more recently, market worries about a hard landing in China and rate hikes in the U.S., combined with uncertainty surrounding the Brexit referendum. Minimum volatility outperformed during all these periods.

What was behind the outperformance of minimum volatility? Was it linked to cheap valuations that have now become expensive? Performance attribution, below, shows that the outperformance of minimum volatility is due to its low beta characteristics, while other factors had negligible impact. As investors flocked to safe, low beta assets in periods of market turbulence, minimum volatility consistently provided relative downside protection.

 

The benefit of less beta

Source: MSCI Research

 

The price-earnings ratio for minimum volatility and the U.S. market peaked at 27.0 and 34.8, respectively in 2001 (below charts). The internet bubble had puffed up the valuations of technology stocks, which in turn inflated the overall market valuation. A minimum volatility index did not hold these volatile securities and therefore had a more modest valuation than the market.

P/E ratios for minimum volatility and for the U.S. market troughed at 14.1 and 13.3 respectively in 2008 during the global financial crisis and currently stand at 24.0 and 22.0. Relative valuations of minimum volatility troughed at a 26% discount in 2002 and peaked at a 28% premium in 2009. The P/E ratio of minimum volatility is now 9% above the market, less than one standard deviation from its historical average.

 

Low volatility is valued well below historical extremes

Price to earnings

 

Relative price to earnings

 

Source: MSCI Research

 

So the market is at above average valuations and minimum volatility trades at a modest premium compared to the market. This premium is well below historical extreme levels. The outperformance of minimum volatility in turbulent markets results from its inherent low beta characteristics and has little to do with valuations. Brexit proved the point emphatically once again. In the three days that followed the referendum, the MSCI World Index dropped by 4.3%, while the MSCI World Minimum Volatility Index only declined by 0.7%.

 

The author thanks Mehdi Alighanbari, Abhishek Gupta and Anil Rao for their valuable insights and assistance.

 

Further reading:

Constructing low volatility strategies

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