Indexes Built to Reduce Volatility—Even in Turbulent Markets
Since the 2008 financial crisis, institutional investors have sought new methods of managing risk and increasing returns while maintaining exposure to equities. That may explain why the MSCI Minimum Volatility Indexes, which historically outperformed in defensive markets, are now the most popular MSCI factor indexes. More than $57 billion in benchmarked assets—in both active and passive portfolios--tracked them as of September 30, 2015, according to data from eVestment, Lipper, Morningstar, Bloomberg and MSCI, reporting at year’s end.
Some low volatility indexes employ a purely ranking-based approach, but those generally focus on the volatility of individual stocks and may ignore the correlation between stocks, which can have significant effects on both diversification and volatility reduction.
The MSCI Minimum Volatility Indexes use an optimization-based approach that avoids many of the pitfalls of purely ranking-based low volatility index construction. While not indicative of future performance, the MSCI World Minimum Volatility Index outpaced its parent MSCI World Index by a cumulative 20 percentage points in the seven years since its launch in 2008.
That led us to question how the index, with its defensive characteristics, would have performed over a longer period. Our new research paper, “Constructing Low Volatility Strategies,” uses a mix of simulations and historical index returns to see how the index would have fared during the four bear markets that occurred between 1988 and 2015.
As this graphs shows, its simulated performance would have outperformed its parent MSCI World Index in each of those market declines, including the extended bear market at the start of the century.
Minimum Volatility Performance in Bear Markets, 1988 to 2015
Volatility levels among countries and sectors can vary widely. For example, stocks of utility companies tend to have low volatility, while the volatility of information technology stocks is generally higher. Creating a low volatility index may result in unintended biases among low volatility countries or sectors, which many investors want to avoid.
Our paper describes the optimization methods employed by the MSCI Minimum Volatility Indexes, designed to constrain unintended high exposures. These optimizations are aided by the use of factor models and explicit constraints to limit sectors, countries and other style factors. Turnover is strictly limited, too.
Our study shows that, during an extended historical period, a carefully constructed low volatility global index would have exhibited enviable characteristics in terms of both risk and return.
To learn more, read the "Research Insight – Constructing Low Volatility Strategies."