By Stephen Cohen
Volatility is not a recent attribute of markets. Markets have been volatile over the last five years, and both the frequency and magnitude of volatile episodes has increased. For example, the MSCI Europe Index has seen daily moves of at least 2% more than three times per month, on average, between 2007 and 2011, while movements of similar magnitude have only occurred approximately five times per annum over the previous five years. As the developed world deleverages, there is uncertainty surrounding politics, future economic policy and the outlook for global growth.
On the one hand, there is an expectation in markets that global economic growth will be slow, but stable going forward. On the other hand, there are concerns that the action of central banks to stimulate economic growth, combined with their low medium-term interest rate policies, could cause growth to actually accelerate. Acceleration in growth could fuel uncertainty about the extent of potential inflationary pressures, and rising rates. In the eurozone, growth forecasts are still negative but some leading indicators are pointing to a pick-up in economic activity. Political risk has also been increasing due to concerns about a new Italian government’s stability and ability to push through reforms. All of these factors are generating uncertainty for investors, an uncertainty which can potentially impact on equity markets looking ahead.
Since volatility can impact on investment portfolios negatively, minimum volatility exchange traded funds (ETFs) could offer investors an interesting alternative. Minimum volatility funds offer equity exposure across popular stock market indices covering the developed world, emerging markets, Europe and the US. An ETF is created from the securities of the parent index using a minimum volatility methodology, which considers not only the volatility of each stock, but also the correlations between stocks within the index. While the methodology overweight the low volatility stocks and underweights the high volatility stocks, constraints are applied to ensure that the minimum volatility fund has sufficient diversification and does not deviate too far from the parent index. Despite the fact that these indices have been created to seek lower volatility than their respective parent indices, they are not low risk in absolute terms. However, minimum volatility ETFs which track these indices do potentially offer less volatile exposure to the underlying market than standard indices and potentially can generate higher risk adjusted returns.
Minimum volatility ETFs track indices which have been designed to smooth out the peaks and troughs of equity market investing. This means while market falls won’t be felt as harshly, the investments will also be less likely to gain from the upside presented by market rises. However, historical analysis available from the MSCI indices looking at rising and falling markets over the past five years, have shown that minimum volatility indices have significantly outperformed standard stock market indices. A region that investors could consider investing in via the use of minimum volatility funds is emerging market equity, which has been an attractive market given its growth characteristics, but has also shown a greater degree of volatility than developed markets. Given their unique proposition, the growth of minimum volatility ETFs is expected to offer a potentially smoother ride in today’s volatile world.
Stephen Cohen is head of investment strategy and insights – EMEA, iShares
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