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Turbulent Times Ahead
By Chin Ping Chia and Dimitris Melas | 24 February, 2012   

Does risk-based strategy diversification work?


Turbulent Times Ahead

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.

Figure 1

For a larger view, please click on the image above.

In order to get a better picture of the historical behaviour of risk-based strategies, we extend the analysis to a longer time period by comparing the performance of these strategies in weeks when equity markets fell by more than five percent. The results in Figure 2 highlight that the MSCI Risk Weighted and Minimum Volatility Indices delivered consistently better performance in extreme market conditions.

Figure 2

For a larger view, please click on the image above.


While risk-based strategies tend to outperform when equity markets are falling, it is important to point out that risk-based strategies tend to lag behind when the markets experience sharp increases. This behaviour is shown in Figure 3.

Figure 3

For a larger view, please click on the image above.

The outperformance in negative return periods can be mainly explained by the fact that the MSCI Minimum Volatility Indices and Risk Weighted Indices have generally lower market beta. Therefore, when the market falls, these indices tend not to fall by as much.

From an asset allocation perspective, adding risk-based strategies to the equity portfolio may help to achieve better portfolio diversification when it is most needed. Consider a hypothetical equity portfolio with pure passive exposure to global equities (proxied by the MSCI World Index) and a blended portfolio with 20% allocation each to the MSCI World Minimum Volatility Index and MSCI World Risk Weighted Index and the remaining 60% to the MSCI World Index. The blended portfolio produced a superior risk and return profile over the past two decades, when compared with the MSCI World Index (Figure 4a).

Figure 4a

Notably, the tail risk characteristics of the blended portfolio also generally improved during the period of analysis. Figure 4b shows that the blended portfolio experienced a maximum drawdown of -51.0%, compared with -53.7% for the MSCI World Index. In addition, the 1-month 95% VaR (Value at Risk) of the blended portfolio was -6.1% against -7.6% for the MSCI World Index during the period of analysis.

Figure 4b

For a larger view, please click on the image above.


DIFFERENCES BETWEEN THE TWO RISK-BASED STRATEGIES

As shown in Figure 4b, the MSCI World Minimum Volatility Index had significantly less risk than the MSCI World Index, while still outperforming it. Specifically, the MSCI World Minimum Volatility Index experienced annualised volatility of 11.6%, compared with 15.6% for MSCI World, over the period June 1988 to December 2011. The risk reduction achieved by the MSCI World Risk Weighted Index, when compared with the MSCI World Index, was lower, but the return enhancement was greater.

Systematic risk premia associated with common factors such as value, size, and volatility are important drivers of long-term portfolio performance. The two risk-based strategies we analyse are designed to capture different risk premia. As the MSCI Minimum Volatility Indices are designed to achieve minimum they mainly capture the low-volatility premium. On the other hand, the MSCI Risk Weighted Indices capture both the low-volatility premium and the size premium. Figure 5 shows the size premium proxied by the performance of the MSCI World Small Cap Index relative to the MSCI World Index. The combination of size premium and low-volatility premium in the risk-weighted strategy has historically enhanced return while providing some risk reduction. However, the pure minimum-variance strategy achieved higher risk reduction, compared with the risk-weighted strategy.

Furthermore, while both indices have historically outperformed the standard, market capitalisation-weighted index during market downturns, the relative performance of the MSCI World Risk Weighted Index has tended to be more stable over time. This can be attributed to the diversification benefit achieved by having two risk premia in the index and by the fact that the MSCI Risk Weighted Index contains all parent index constituents.

Figure 5

Conclusion

Risk-based strategies aim to provide alternative beta exposure for institutional investors through an objective and transparent index construction process. We use the MSCI Minimum Volatility Indices and MSCI Risk Weighted Indices as proxies to analyse the behaviour of risk-based strategies.

These MSCI Risk Premia Indices have historically enjoyed lower risk and higher risk-adjusted performance than their respective capitalisation-weighted counterparts from the MSCI range. Risk-based strategies typically outperform the market in periods of extreme risk but tend to lag during market rallies. While this may suggest that risk-based strategies are efficient tools for tactical asset allocation in bear markets, low-volatility strategies have outperformed their higher-volatility counterparts in absolute terms over the long term as well. Therefore the application of risk-based strategies for capturing the low-volatility effect may be more appropriate for a long-term investment strategy than for short-term risk reduction.

Endnotes And References

  1. Launched in April 2008, the MSCI Minimum Volatility Indices are optimisationbased and utilise historical variances and covariances of stocks to minimise exante risk. The MSCI Risk Weighted Indices were launched in April 2011 and use the inverse of the historical variance to weight stocks. Both Risk Premia Indices tend to reduce realised volatility over the historical period of analysis, as shown in Melas, Briand and Urwin (2011).
  • Melas, Dimitris, Briand Remy, and Urwin Roger. 2011. "Harvesting Risk Premia with Strategy Indices: From Today's Alpha to Tomorrow's Beta."MSCI Research Insight.



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