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.
MSCI Understating Risks
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 to 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 makeup of the min-vol portfolio?
- How would today’s min-vol portfolio behave during more recent interest rate spikes?
Min-Vol Underperforms 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 second 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 2 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
|Multifactor ETF||Ticker||Est. Market Beta||Est. Total Risk||Profitability||Yield|
|iShares Edge MSCI Min Vol USA||USMV||0.77||9.08||0.32||0.20|
|PowerShares S&P 500 Low Volatility Portfolio||SPLV||0.72||8.98||0.31||0.29|
|SPDR S&P 500 ETF||SPY||1.00||10.95||0.10||0.08|
Source: Bloomberg PORT as of 3/10/2017
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 vs. the S&P 500 Under Rising Rate Scenarios
|+1% US 10-Yr Treasury||+1% Interest Rates|
Source: Bloomberg PORT as of 3/10/2017
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 15, 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.