23. May 2019
10 minutes

How does interest rate affect performance?

The relative performance of the minimum variance portfolios primarily depends on the development of the stock market and not on the level of interest rates.

Low-risk strategies are often improperly associated with investments in securities with a high level of debt and an abnormal interest rate sensitivity. Therefore, investors are worried of a substantial underperformance of those strategies should interest rates rise from their current low or even negative level. Among other sources [1], our Research Note 01.2017 [2] addresses this topic: the average leverage of our minimum variance portfolio is not higher than the one of the market and, most importantly, the predominating factor is not interest rate sensitivity but rather economic growth- respectively stock market dynamic.

In this blog post, we investigate whether there is a systematic out- or underperformance of OLZ Minimum Variance portfolios against the corresponding market-capitalization indexes during certain stock market and interest rate regimes. Our study covers the period from 31.05.2002 until 31.10.2018 for the following four regions: USA, Eurozone, Japan and Australia. Market and interest rate regimes are classified using the Harding-Pagan algorithm [3].

The Effect of Market Conditions

We start by analyzing the average monthly excess return of the minimum variance strategy conditional to market regimes (see figure 1). In market downturns, the minimum variance strategy outperforms substantially across all equity universes, while it underperforms during bull market regimes. This behavior is a well-known characteristic of low-risk strategies, and it results, on average andover the long term,in an outperformance.

Figure 1: Outperformance of Minimum Variance by Equity Market Regimes (Up- vs. Down-Market):

The Effect of Interest Rate Movements

We repeat the same analysis but this time distinguishing between regimes of increasing and decreasing interest rates, measured by 10y government bond yields (see figure 2). Our finding is that minimum variance portfolios achieves an outperformance in periods of decreasing interest rates, whereas it underperforms when interest rate levels increase. However, the impact of interest rates regimes is considerably smaller than that of the stock market regime, making interest rates a secondary factor in explaining the dynamics of the outperformance of the minimum variance strategy.

Figure 2: Outperformance of Minimum Variance by Interest Rate Regimes (Up- vs. Down-Market):

In order to gain a more detailed understanding of the equity market and interest rate regimes influence on the minimum variance strategies’ outperformance, we finally consider them jointly.

From figure 3, we see that the market regime’s impact on the relative performance of the minimum variance portfolio is much stronger than the one of the interest rate regime.

This finding holds across all the considered universes: no matter what happens to the interest rate, when the stock market performs negative, Minimum Variance outperforms and vice versa.

Overall, the highest outperformance of the minimum variance portfolio is observed when both the stock markets and interest rates fall. This is typical for a severe market downturn, resulting in a flight to safe haven investments, which pushes yields down. On the contrary, the minimum variance performance sufferd the most in bull markets with declining interest rates.

Figure 3: Outperformance of Minimum Variance by Equity Market and Interest Rate Regimes (Up- vs. Down-Market):


Summarizing our analysis, we arrive at four main findings:

  • Bull and bear market regimes are the main driver of minimum variance portfolios outperformance;

  • Minimum variance portfolios outperform in declining markets, even when interest rates rise simultaneously;

  • Minimum variance portfolios have the strongest outperformance when equity market and interest rates decline simultaneously, i.e., in severe market downturns.

  • In bull equity markets the underperformance of minimum variance is smaller when interest rates increase.

The outperformance of the minimum variance portfolio is highest when both, the stock markets and interest rates, fall.

In conclusion, evidence does not support the claim that low risk strategies are characterized by investing in securities having a high debt level and hence a high interest rate sensitivity. In particular, segmenting the minimum variance strategy performance according to interest rate and market dynamic makes clear that the latter is the driver of under-outperformance.

[1] “What has Affected Minimum Volatility Index Performance?”, W. Virgaonkar and M. Alighanbari (2019), MSCI blog post
[2] “Minimum variance – a differentiated analysis of crowding, valuation, interest rate sensitivity and further questions”, C. Orlacchio (2017), OLZ Research Note 01/2017
[3] The Harding-Pagan algorithm is a development on the Bry-Boschan Business Cycle Dating Procedure (“Dissecting the cycle: a methodological investigation”, D. Harding, A. Pagan, Journal of Monetary Economics, 2002, Vol. 49, Issue 2, 365-381). Its first application has been to the classification of business cycles in GDP time series. In this blog, we use it to identify regimes in stock markets, as well as in interest rates dynamics.

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