popular min vol strategies

We ran this post a few weeks ago and, although it was quite popular, we got a few comments asking us for performance data for the hypothetical portfolios.  I had originally omitted returns because I wanted to focus on the risk-adjustment aspect of these strategies.  However, since a few of you asked, I thought I’d oblige. By now, you’ve probably heard about the potential benefits of a minimum volatility (or, “min vol”) strategy and the ETFs that seek to deliver them, but you might still be wondering how to use these funds in a portfolio.  One common misconception is that min vol ETFs are tools designed for volatile markets specifically, but this simply isn’t the case.  In fact, the two minimum volatility ETF strategies we see our clients using most often are both strategic, long-term plays that have nothing to do with current market volatility.  These two strategies are: 1) seeking to lower overall portfolio risk or 2) endeavoring to increase allocation to equities without increasing overall portfolio risk. Lower overall portfolio risk Investors who are trying to lower their overall portfolio risk could consider replacing their existing market capitalization based equity investment with the corresponding minimum volatility ETF. For example, let’s say a hypothetical portfolio consists of 60% equity and 40% fixed income. Let’s use the MSCI USA Index to represent “equity” and the Barclays US Aggregate Bond Index to represent “fixed income”. Now let’s replace the 60% allocation to the MSCI USA Index with a 60% allocation to the MSCI USA Minimum Volatility Index and analyze the results.

LowerRiskPortfolioGraph

This strategy would have resulted in a ~20% reduction in portfolio risk since inception of the analysis (June 2008) and an even greater reduction in risk, as defined by standard deviation, in the nearer term (see below).

AnnualizedRiskreturngraph

Hypothetical portfolio risk and returns are based on index returns using the allocations as specified above. Other allocations, asset classes and time periods may have different results. Index returns are for illustrative purposes only and do not represent actual iShares Fund performance. Index performance returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results. For actual iShares Fund performance, please visit www.iShares.com or request a prospectus by calling 1-800-iShares (1-800-474-2737).

Increase allocation to equities without increasing overall portfolio risk

Like the example above, an investor looking to employ this strategy could consider replacing their existing market capitalization based equity investment with the corresponding minimum volatility ETF, but then they could also increase their allocation to the minimum volatility ETF while decreasing their allocation to fixed income. In our hypothetical portfolio, after replacing the MSCI USA Index with the MSCI USA Minimum Volatility Index, we could increase the allocation to the MSCI USA Minimum Volatility Index and decrease the allocation to the Barclays US Aggregate Bond Index until the total portfolio risk reaches the level desired – for example, a level of portfolio risk that is just below the since inception risk of the Original Portfolio, which is 12.15%.

EquityPortfolioGraph

 

This strategy would allow us to increase the allocation to equity by 17% while obtaining a consistently lower level of risk than the Original Portfolio (see below).

AnnualizedRiskReturngraph2
Hypothetical portfolio risk and returns are based on index returns using the allocations as specified above. Other allocations, asset classes and time periods may have different results. Index returns are for illustrative purposes only and do not represent actual iShares Fund performance. Index performance returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results. For actual iShares Fund performance, please visit www.iShares.com or request a prospectus by calling 1-800-iShares (1-800-474-2737).

While there are certainly other ways to employ minimum volatility ETFs in a portfolio, our team has found that these two strategies are the most commonly used among our clients.

Markov Processes International (MPI):

 This information should not be relied upon as research, investment advice or a recommendation regarding the iShares Funds or any security in particular. This information is strictly for illustrative and educational purposes. Investors should discuss their own portfolio allocation with their advisors.
The iShares Minimum Volatility Funds may experience more than minimum volatility as there is no guarantee that the underlying index’s strategy of seeking to lower volatility will be successful.