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Adding Alpha to Minimum-Volatility Equity Strategies

In the aftermath of the Global Financial Crisis, minimum-volatility (min-vol) equity strategies have become popular among investors. For investors with a very limited risk tolerance who place a high priority on minimizing the prospect of short-term drawdowns, min-vol strategies may be a good fit. But for investors seeking to maximize risk-adjusted returns, recent research by Hao Yin, senior portfolio manager on the Active Quantitative Equity team at State Street Global Advisors, suggests that defensive equity strategies – which have a dual return and risk mandate – may lead to better outcomes.

In order to explore the full potential of min-vol strategies, Hao focused his research on testing the outer boundaries of their improvement. Because min-vol focuses exclusively on reducing risk, a key issue to explore is whether more accurate information – a more accurate view into the future – would meaningfully improve performance. If so, how much more accurate would that information have to be?

To answer this question, Hao fed future stock-risk information based on increasingly accurate foresight into a typical min-vol strategy. Then he compared those results with those obtained using a commercial risk model. He learned that incrementally better stock-level volatility forecasts are not substantially superior to the base-case portfolio. A typical min-vol strategy would have to be granted near-perfect foresight – an extraordinarily high bar to reach – to show meaningful improvement.

By contrast, introducing an outperformance- or alpha-seeking component as an additional information dimension was a much more fruitful approach. A very simple alpha-seeking component, added to the min-vol strategy at a very low weight, produced a Sharpe ratio (a measure of risk-adjusted returns) similar to that obtained with a fairly large amount of additional risk foresight. Further outperformance could of course be captured by more sophisticated alpha models, as commonly used by the industry in practice.

It’s certainly worth pointing out that the introduction of alpha does come at the cost of slightly higher portfolio risk, which can sometimes result in bigger drawdowns. But for the many investors who are compelled by their requirements to strike a fruitful balance between return and risk, Hao’s research suggests that well-constructed defensive equity strategies may be the most useful avenue.

For more information, please email us at or contact your State Street Global Advisors relationship manager for the full research paper.