24 February, 2012
Does risk-based strategy diversification work?
Last year was marked by great volatility for global equity investors. Given the apparently increasing frequency of events such as the European debt crisis and the US credit rating downgrade, what can investors do to protect their portfolios against downside risk?
Since the last financial crisis, there has been growing interest amongst institutional investors in considering the application of risk-based investment strategies in their equity allocation. While the key motivation is often the need to cushion and diversify extreme risk, the possibility of capturing the "low-volatility effect" provides an additional incentive for the adoption of risk-based investment strategies.
In this article, we examine the historical behaviour of two risk-based investment strategies and investigate their potential application in an institutional equity portfolio.
HISTORICAL PERFORMANCE OF RISK-BASED STRATEGIES
In general, risk-based strategies aim to achieve superior risk-adjusted performance (Sharpe ratio) relative to the market, primarily by tilting the portfolio towards low-volatility stocks. Examples of such strategies include minimum-variance and risk-weighted portfolios. Below, we use the MSCI World Minimum Volatility Index and the MSCI World Risk Weighted Index as proxies for these two strategies. These indices are part of the MSCI Risk Premia Indices family.1
Figure 1 examines the performance of major MSCI capitalisation-weighted equity indices against the respective MSCI Risk Weighted and Minimum Volatility Indices in the third quarter of 2011, a period associated with the European debt crisis and the US credit rating downgrade. We also present the performance for the entire year 2011. It is interesting to note that the two risk-based indices have cushioned the fall in equity markets and provided relative downside protection during this period. Outperformance of risk-based strategies was a consistent phenomenon across all geographical regions in 2011.
For a larger view, please click on the image above.