The two most common approaches to U.S. equity low-volatility investing can be categorized as risk-metric ranking and minimum variance.
- Typically involves sorting an index based on various volatility metrics (e.g. beta, historical volatility, etc.) and selecting stocks in the most attractive (i.e., least volatile) percentiles
- Creates a portfolio with a targeted proportion of names or capitalization relative to the full index
- Associated index: S&P 500 Low Volatility Index (SPLVI).
- Generally looks beyond simple volatility metrics by incorporating correlations among securities and using optimization models
- Creates a basket of holdings with the lowest levels of expected portfolio variance and may apply constraints
- More quantitatively rigorous and may involve some subjective judgments with respect to model inputs—but it is generally accepted that these factors are more stable over time
- Associated index: MSCI USA Minimum Volatility Index (MSMV).
- Downside disappointments – the market was down but the low-volatility portfolio was down more.
- Upside disappointments – the market was up, but the low-volatility portfolio actually produced negative returns.
Our research also found that the portfolio construction processes for SPLVI and MSMV may have inadvertent embedded risk factors (e.g. growth, value, interest rates, etc.) that can significantly impact performance.