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Defensive equity indexes can vary substantially, even during market crashes, and in many ways more closely resemble active strategies than their cap-weighted counterparts. The Journal of Index Investing recently featured a paper by Intech that examines the pros and cons of MSCI Minimum Volatility Index construction to help you better evaluate your defensive equity managers. Below is a brief excerpt from the article, but we invite you to learn more with complementary access to the journal.

Construction Methodology

MSCI’s Minimum Volatility indexes begin with a cap-weighted parent index (e.g., the MSCI USA or MSCI World) that serves as the eligible investment universe. From there, they quantitatively optimize for the lowest absolute volatility, using a covariance matrix based on Barra Equity Models and subject to a number of constraints for risk and investability reasons (see MSCI Minimum Volatility Index: Optimization Constraints below for a comprehensive list).

MSCI MINIMUM VOLATILITY: OPTIMIZATION CONSTRAINTS

  • The maximum weight of an index constituent will be restricted to the lower 1.5% or 20 times the weight of the security in the parent index.
  • The minimum weight of an index constituent will be 0.05%
  • For countries with weight greater than 2.5% in the parent index, the weight in the MSCI Minimum Volatility Index will not deviate more than +/-5% from the country weight in the parent index.
  • For countries with weight less than 2.5% in the parent index, the weight in the MSCI Minimum Volatility Index will be capped at 3 times their weight in the parent index.
  • The sector weights of the MSCI Minimum Volatility Index will not deviate more than +/-5% from the sector weights of the parent index.
  • No constraint will be applied on the exposure of the MSCI Minimum Volatility Index to the Barra Volatility risk index factor. Exposure to all other Barra risk index factors will be restricted to +/-0.25 standard deviations relative to the parent index.
  • The one-way turnover to the MSCI Minimum Volatility Index is constrained to a maximum of 10% (per reconstitution).
Source: MSCI, May 2018.

The index is re-optimized with new constituents and weights just twice a year. In between reconstitutions, MSCI maintains the covariance matrix with monthly updates, using the latest version at the time of the semi-annual optimizations.

The Results

The results of this construction methodology are benchmark portfolios that differ substantially in composition from their comparable parent index (see below). Some key distinctions are relevant for active managers using the Minimum Volatility Indexes as their investment benchmarks.

INDEX COMPOSITION MINIMUM VOLATILITY

For starters, the much smaller universe of stocks represents a narrower opportunity set. (Even if an active manager is willing to invest outside of the benchmark universe, the risks of style drift and higher-than-acceptable tracking error necessarily limit the proportion of the portfolio invested in this way.) Beyond that, the characteristics currently associated with stocks that are more defensive are apparent in lower P/E, higher dividend yield, and a less growth-oriented stance. Finally, the differences in market cap are substantial, with a clear preference for the smaller end of the capitalization spectrum within the parent index.

Accompanying these differing characteristics are returns that are competitive with cap-weighted indexes over the long term (in simulation), and are even more attractive when you consider their lower beta and lower volatility that results in notably higher Sharpe ratios (see below). Despite strong risk-adjusted performance on an absolute basis, such divergence from the broad market comes with periods of underperformance, while the tracking error often approaches double digits over short periods.

INDEX PERFORMANCE MINIMUM VOLATILITY

Implementation Challenges

While defensive equity strategies come in many shapes and sizes, let’s consider these Minimum Volatility Indexes as a useful proxy for the category from the perspective of active risk. The deviation in performance compared with their respective cap-weighted indexes can create an issue for plan expectations. Devising the appropriate way to measure the effectiveness of these strategies over less than a full market cycle can be vexing, especially in long, stable up-market periods while awaiting the next severe drawdown or volatility event.

Their asymmetric performance contours should be expected to be inherently more dynamic than the typical active manager whose primary objective is to beat the market year in and year out. Consequently, a defensive equity strategy working precisely as designed may still underperform the cap-weighted index for longer periods than plan sponsors would like to have to explain.

Many investors are able to integrate this behavior into their equity portfolios without issue; they’re comfortable with the high tracking error relative to a cap-weighted index and are content to employ other risk and efficiency metrics for short-term analysis (e.g., standard deviation, beta, Sharpe ratio, downside capture, etc.), retaining a long-term comparison relative to the cap-weighted index.

For plans that aren’t easily able to accommodate this approach, however, an alternative exists: change the benchmark. Substitute a defensive equity index, such as MSCI’s minimum volatility offerings, for the usual cap-weighted benchmark, or at least consider this as a secondary benchmark. The benefits for the investment decision-makers here are twofold. First, the new benchmark provides a clear reference for measuring and attributing a manager’s performance for their board. Second, it allows the inclusion of a defensive component within their equity portfolio with all of the potential advantages that entails, while allowing the possibility of added returns from a skilled manager.

Explore an Active Approach

We’ve detailed the benefits – and limitations – of Minimum Volatility Indexes. But we believe you can do better. The right active strategy can build upon these indexes for added return, within a tracking error range you can be comfortable with. Learn more in our latest paper featured in The Journal of Index Investing.

Intech Featured in The Journal of Index Investing Get Complimentary Access

 

The information expressed herein is subject to change based on market and other conditions. The views presented are for general informational purposes only and are not intended as investment advice, as an offer or solicitation of an offer to sell or buy, or as an endorsement, recommendation, or sponsorship of any company, security, advisory service, or fund nor do they purport to address the financial objectives or specific investment needs of any individual reader, investor, or organization. This information should not be used as the sole basis for investment decisions. All content is presented by the date(s) published or indicated only, and may be superseded by subsequent market events or other reasons. Past performance is no guarantee of future results. Investing involves risk, including possible loss of principal and fluctuation of value. An index is not available for direct investment; therefore, its performance does not reflect the expenses associated with the active management of an actual portfolio.
MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein, if shown. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This information has not been approved, reviewed, or produced by MSCI.