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S&P Dow Jones Indices

Low Volatility and Minimum Volatility are not the Same

Low Volatility and Minimum Volatility are not the Same

May. 15 2019 — Global equities have been turbulent recently as a combination of stalled trade negotiations and announcements of tit-for-tat tariffs increased the prospect of a trade war between the U.S. and China.  After its historic start to the year, the S&P 500 is down 3.7% so far in May, while many other markets have also faltered month-to-date.  Amid the recent market jitters, many investors may be interested in strategies that help navigate periods of heightened volatility.

Many index-based strategies are designed to ride out turbulent times.  Among the most popular defensive equity strategies are low volatility and minimum volatility indices.  However, while both strategies are based on the low volatility anomaly and have similar names and objectives, they are constructed differently.  Low volatility indices rank constituents by their trailing volatility and select the least volatile stocks, whereas minimum volatility indices use an optimization-based approach to construct the least volatile portfolio.  Hence, low volatility indices comprise only low volatility stocks, whereas minimum volatility indices may contain highly volatile stocks.  Exhibit 1 shows the differences in portfolio construction for the S&P 500 Low Volatility Index and the S&P 500 Minimum Volatility Index.

Exhibit 1: Low & Minimum Volatility Indices are constructed differentlySource:  “Inside Low Volatility Indices”.  Table is provided for illustrative purposes.

Exhibit 2 shows that the differences in methodologies impacted the indices’ risk/return profiles: the S&P 500 Low Volatility has offered greater downside protection – and higher risk-adjusted returns – than its minimum volatility counterpart since December 1990.  Indeed, the low volatility index typically captured less than half of S&P 500’s total return in “down” months (determined by whether the S&P 500 posted a monthly decline), compared to around 70% for the minimum volatility index.

Exhibit 2: Low & Minimum Volatility Indices Behaved Differently

Another difference between low and minimum volatility indices is their geographic revenue exposure: around 80% of the S&P 500 Low Volatility’s revenues come from the U.S, compared to 66% for the S&P 500 Minimum Volatility.  Exhibit 3 helps to explain this result; it shows the sector exposures (height of the bars) and the domestic revenue exposures (bar labels) of companies within each sector for each index.  Clearly, the low volatility index has sizable allocations to more domestically-focused companies, especially within the Utilities, Real Estate, and Financials sectors.  On the other hand, the S&P 500 Minimum Volatility has greater exposure to companies that are more reliant on revenues from abroad.

Exhibit 3:  Low & Minimum Volatility indices may have different revenue exposures

As a result, while low and minimum volatility strategies have similar sounding names and objectives, they can behave differently over time.  Combined with differences in sectoral allocations and geographic revenue exposures, and how this may impact performance in the event of an escalation of trade tensions, market participants may be well served to take a deeper look inside low volatility indices.