As minimum volatility investments gain popularity, clients are asking me if investments that track minimum volatility indexes can be used as a tool to “time” exposure to the equity market during risk-off periods. While it’s an interesting question, I think it overlooks the real benefit of this kind of exposure in an investment portfolio.
To me, the value of a relatively low-risk investment like a minimum volatility portfolio is not its low risk, but how its returns can compare with those of a capitalization-weighted equity portfolio, or a so-called market portfolio. I would argue that a minimum volatility portfolio of equities potentially offers a better way for long-term investors to invest in equities – even if they have no interest in the lower risk that these portfolios provide.
Yes, I know. To many readers, this might seem like a bold statement. After all, according to modern portfolio theory, the market portfolio (aka the cap-weighted equity portfolio) is generally considered to be theoretically “efficient” in that it should provide the best possible trade-off between risk and return.
Let’s look at the traditional “portfolio frontier” chart that can be found in almost every introductory finance textbook.
The chart shows that over the long run, equity markets are expected to reward riskier assets with higher returns. In this case, the market portfolio (the cap-weighted equity portfolio) is expected to provide the highest level of return for its level of risk, while the low risk minimum volatility portfolio should provide commensurately lower returns.
The problem with this picture is that a wide range of empirical studies have found that the market portfolio does not appear to deliver enough additional return to compensate an investor for the additional risk it takes compared with the minimum volatility portfolio.
Let’s look at this modified chart:
This chart shows that, contrary to standard finance theory or assumptions made by many asset allocation tools used by investors, the market has not appeared to appropriately price risk. In academic literature this has been called the “low risk anomaly” – higher risk does not always translate into higher returns. Significant academic work, including our own, has gone into pinpointing explanations for this anomaly, which I will delve deeper into in the next installment of this blog.
For the purpose of today’s blog, however, I’d point out that there is strong empirical data that equity investors should consider minimum volatility as a strategic holding, not just a tactical play. Minimum volatility portfolios can potentially deliver similar returns to those of the cap-weighted equity portfolio but with lower overall risk, in effect providing a possible replacement for the traditional market portfolio in a buy-and-hold strategy.
 See for example, the following references:
Baker, Bradley and Wurgler (2001), “Benchmarks and Limits to Arbitrage,” FAJ, Vol 67, Number 1
Ang, Hodrick, Xing an Zhang (2006), “The Cross-section of Volatility and Expected Returns,” Journal of Finance, Vol 61, Number 1
Clarke, de Silva, Thorley (2006), “Minimum-Variance Portfolios in the U.S. Equity Market,” Journal of Portfolio Management, Vol 33, Number 1