Insights

Adding Alpha to Minimum-Volatility Equity Strategies

December 12, 2019

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 AQE@ssga.com or contact your State Street Global Advisors relationship manager for the full research paper.

Footnotes

¹ Note that, although min-vol strategies are generally less vulnerable to drawdowns in the short term, over the longer periods of time needed to realize the associated premium, min-vol strategies can suffer substantial drawdowns.

Glossary

Defensive equities: While the term is generally used in connection with stocks that possess defensive characteristics, such as stable cash flows and lower volatility, it may also be used to refer to lower-risk securities such as government bonds and preferred shares. Defensive stocks may outperform their flashier counterparts like growth stocks during periods of economic uncertainty when equity markets display a declining trend, but will underperform during periods of economic expansion.

Low volatility investing: Low volatility investing means putting your money in stocks with lower price fluctuations.

Sharpe Ratio: In finance, the Sharpe ratio (also known as the Sharpe index, the Sharpe measure, and the reward-to-variability ratio) measures the performance of an investment (e.g., a security or portfolio) compared to a risk-free asset, after adjusting for its risk. It is defined as the difference between the returns of the investment and the risk-free return, divided by the standard deviation of the investment (i.e., its volatility). It represents the additional amount of return that an investor receives per unit of increase in risk.

Disclosures

The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor. All material has been obtained from sources believed to be reliable. There is no representation or warranty as to the accuracy of the information and State Street shall have no liability for decisions based on such information.

The views expressed are the views of Hao Yin through November 30, 2019 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Investing involves risk including the risk of loss of principal.

Actively managed funds do not seek to replicate the performance of a specified index. Equity securities may fluctuate in value in response to the activities of individual companies and general market and economic conditions. Investing in foreign domiciled securities may involve risk of capital loss from unfavorable fluctuation in currency values, withholding taxes, from differences in generally accepted accounting principles or from economic or political instability in other nations.

For use in EMEA:
The information contained in this communication is not a research recommendation or ‘investment research’ and is classified as a ‘Marketing Communication’ in accordance with the Markets in Financial Instruments Directive (2014/65/EU) or applicable Swiss regulation. This means that this marketing communication (a) has not been prepared in accordance with legal requirements designed to promote the independence of investment research (b) is not subject to any prohibition on dealing ahead of the dissemination of investment research.

All the index performance results referred to are provided exclusively for comparison purposes only. It should not be assumed that they represent the performance of any particular investment.

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Exp. Date: 12/31/2020

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This information is for informational purposes only, not to be construed as investment advice or a recommendation or offer to buy or sell any security. Investors should always obtain and read an up-to-date investment services description or prospectus before deciding whether to appoint an investment manager or to invest in a fund. Any views expressed herein are those of the author(s), are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may make different investment decisions for different clients. There are no guarantees regarding the achievement of investment objectives, target returns, portfolio construction, allocations or measurements such as alpha, tracking error, stock weightings and other information ratios. The views and strategies described may not be suitable for all investors. SSGA does not provide tax or legal advice. Prospective investors should consult with a tax or legal advisor before making any investment decision. Investing entails risks and there can be no assurance that SSGA will achieve profits or avoid incurring losses.

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