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By Robert Hum, CAIA, U.S. Head of Factor ETFs; Ken Baba, CFA, Factor Strategist; Jim Fuson, CFA, Factor Strategist
Key Takeaways
- Minimum volatility ETFs can help investors during periods of heightened volatility and geopolitical uncertainty.
- Negative returns can have dramatic effects on portfolio performance. Attempting to reduce downside risk can result in more favorable returns over the long term.
- Minimum Volatility has not only had strong relative performance YTD, but it has also reduced portfolio volatility over the long run.
Paul “Bear” Bryant, the legendary football coach of the Alabama Crimson Tide, once said, “offense wins games…defense wins championships.” That sentiment can be also applied to investing, where limiting downside risk of a portfolio can be just as important, if not more so, than maximizing upside potential. Given the current backdrop of heightened volatility and geopolitical uncertainty, it is critical that investors appropriately consider how to manage investment risk and properly diversify their portfolios. The iShares minimum volatility suite represents a set of tools that investors can use to help reduce volatility and mitigate downside capture with the goal of staying invested in equity markets when markets get bumpy.
Time In The Market, Not Timing The Market
An important factor when determining whether an investor achieves their desired outcomes is their ability to stay invested over the long term. This can be challenging, as investors are often tempted into buying equities in periods of strong performance, only to sell those same securities when performance becomes challenged. The benefit of staying invested through turbulent market cycles is illustrated in the graph below, which shows that missing out on the market’s top returning days can have a dramatic impact on a portfolio’s ending value.
Exhibit 1: Missing top-performing days can hurt your return
Source: BlackRock, Bloomberg as of 12/31/21. Stocks are represented by the S&P 500 Index, an unmanaged index that is generally considered representative of the US stock market. Index performance is for illustrative purposes only. Index performance does 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.
Chart description: Bar chart that shows the hypothetical growth of a $100k investment in the S&P 500 Index (over the last 20 years) and the long term effect of missing out on some of the market’s best days due to investors hypothetically selling equities when markets are volatile.
In short, since trying to time the market is extremely difficult staying the course and remaining invested may be prudent. Having said that, many investors would most likely prefer to lessen the pain of a market crash. One potential solution for investors is to focus on the stocks that tend to not climb as high or fall as low as other stocks, known as minimum volatility investing. These strategies can help mitigate the inherent behavioral bias of trying to time the market by pursuing consistent returns during both up markets and down markets – giving investors more confidence in maintaining their equity positions during market uncertainty.
Managing Downside Risk
Investors who can tolerate market swings can benefit from managing a portfolio’s downside risk, as negative returns can have an outsized impact on performance. For example, suppose that the market falls by 50% and then rebounds, rising by 50%. In this scenario, an investor may intuitively think that they’ve broken even, while their portfolio is actually down -25%. In reality, the investor would need a 100% return to break even from a 50% drop.
Exhibit 2: The Arithmetic of Losses
| Investment loss | Return needed to break even |
|---|---|
| 10% | 11% |
| 20% | 25% |
| 30% | 43% |
| 40% | 67% |
| 50% | 100% |
For illustrative purposes only.
In other words, reducing the amount you could lose in a selloff can lead to more favorable returns over time, helping investors to grow their wealth over the long run.
Minimum Volatility Performance
The return of volatility, and subsequent market selloff this year, serves to illustrate the potential benefit of a minimum volatility approach. When looking at year-to-date performance of domestic, international developed, and emerging markets, performance has been challenging thus far in 2022. Minimum volatility strategies in each region outperformed their broad market counterparts, as evidenced by the below MSCI minimum volatility indexes:
Exhibit 3: Returns of various minimum volatility indexes
Source: Morningstar Direct as of 5/13/22. Relative performance calculations may differ slightly due to rounding. Index performance is for illustrative purposes only. Index performance does 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.
Chart description: Bar charts that show the YTD and trailing 1-year returns (through 5/13/22) of min vol indexes in the US, International Developed Markets, and Emerging Markets. During the time period measured, the above highlighted min vol indexes outperformed their broad market counterparts.
The iShares MSCI USA Min Vol Factor ETF (USMV), iShares MSCI EAFE Min Vol Factor ETF (EFAV), and iShares MSCI Emerging Markets Min Vol Factor ETF (EEMV) seek to track the minimum volatility indexes listed above. YTD, and over the trailing 1-year period, each benchmark min vol index has outperformed their respective broad market benchmarks with meaningfully lower risk1. Since inception, each index has also been successful at mitigating downside risk with downside capture ratios of less than 70%2.
The iShares minimum volatility suite can be a valuable set of tools for investors who are looking to maintain their equity exposure in a volatile market environment.
Summary
While reducing overall portfolio risk may not be as exciting as generating market beating returns, Paul “Bear” Bryant reminds us of the importance of defense. Using minimum volatility strategies can help ensure investors stay invested through turbulent markets, so they are able to “be there” to capture underlying market returns.
© 2022 BlackRock, Inc. All rights reserved.
1 Using performance data (from 11/1/2011 through 5/13/22), the MSCI USA Minimum Volatility Index has had ~16% less risk than the S&P 500 Index. The MSCI EAFE Minimum Volatility Index has had ~25% less risk than the MSCI EAFE Index. The MSCI EM Minimum Volatility Index has had ~24% less risk than the MSCI EM Index.
2 Since Nov 2011, the MSCI USA Min Vol Index, MSCI EAFE Min Vol Index, and MSCI EM Min Vol Index have had downside capture ratios of 68%, 61%, and 67% respectively.
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This post originally appeared on the iShares Market Insights.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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