We doubt that the growth of investments in minimum variance over recent years has been due solely to the superior efficiency of this approach compared to the cap-weighted market index, especially since this evidence was provided by empirical financial market research decades ago. Rather, the exceptional market situation of negative or low interest rate policy worldwide, combined with a number of political, geopolitical and economic risks, will have led to this increase.
Because there is a lack of alternative investment opportunities, many investors are increasing their equity quota to reach their return target. For this reason, they must pay more attention to portfolio risk when planning asset allocation. In this way, they consciously or unconsciously take into account Markowitz’s core contribution to modern portfolio theory: optimising portfolio risk and portfolio diversification. Risk-based approaches are helpful in this context because they create degrees of freedom for decision-makers to optimise the use of the risk budget.
However, despite increasing acceptance, risk-based strategies continue to have a tough time on the market. Many investors are unaware that they are not only superior to the ‘Holy Grail’ of the market-capitalised index in terms of risk, but in the long term, they are also superior regarding return. Even scientific evidence cannot eliminate the widespread scepticism.
In this research note, we address the arguments of critics who are calling into question the added value of minimum variance, and who see confirmation of their reservations in the 2016 underperformance. In the following, we explain why these arguments do not apply and why it is worthwhile for investors to focus in the long term on optimised diversification and risk management, even when outperformance is not expected during a longer phase of unusually low market volatility, as in 2016.
1. Is there a risk of bubble formation with minimum variance?
The volume of risk-based strategies is small compared to index funds and ETF. Moreover, the approaches and their portfolios are different.We have identified 73 ETFs and 75 investment funds in Bloomberg which invest in minimum variance, low volatility or similar risk-based approaches. For this group, we have analysed the assets and cash flows (net subscriptions) at the end of September 2016. This period was chosen because the risk-based strategies achieved a strong underperformance in the following (fourth) quarter.
At the end of September, the selected products reported managed assets of USD 53 billion (ETF) or USD 38 billion (investment funds) under management. The total sum of USD 91 billion corresponds to less than half of the spider, the largest ETF on the S&P 500 with a volume of USD 195 billion. Although risk-based ETFs from September 2015 to September 2016 claimed almost 12 % of all equity ETF inflow and the assets under management nearly doubled, their share of the total investment volume in equity ETFs of USD 2.7 trillion was still marginal at around 2 %.
Risk-based strategies do not form a monolith – in total contrast to cap-weighted index funds / ETFs where the portfolio structures of the different providers are exactly the same. In the case of risk-based approaches, there are various strategies such as low volatility (selection of securities with the lowest volatility), minimum variance or minimum volatility (optimisation of securities weighting of the portfolio with lowest volatility). The implementations of the different providers differ even within the same strategy.
Figure 2 illustrates how different risk-based strategies differ: