Min Vol ETFs Underperform When Rates Rise

March 16, 2017

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by Ben Lavine, chief investment officer of 3D Asset Management based in East Hartford, Connecticut.

I’ve written about minimum-volatility strategies in prior ETF.com posts, but 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 like the PowerShares S&P 500 Low Volatility Portfolio (SPLV), the low volatility portfolio iShares Edge MSCI Min Vol USA ETF (USMV) or a low-volatility portfolio with bells and whistles like the Legg Mason Low Volatility High Dividend ETF (LVHD).

More Like Equities Than Fixed Income

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, so 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 they hold diversified baskets of equities (not bonds), even if those baskets may be concentrated in certain interest-rate-sensitive sectors such as utilities.


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