In order to improve risk-adjusted returns, Mercer has, for more than a decade, advocated an allocation to defensive equity strategies as a component of an investor’s overall equity portfolio. However, active returns for systematic low volatility (targeted volatility) strategies, a popular and low-cost defensive equity option, have disappointed over the last decade, raising questions about their efficacy for many investors.
While a passively managed low volatility index may be appropriate for some constrained investors, we believe that active targeted volatility strategies should remain the preferred approach for most investors. This is because active strategies are typically better placed to mitigate the risks associated with investing in this segment of the market.
Figure 1 shows that low volatility equity indexes have not only delivered on their objective of reducing the absolute volatility of returns, they have generated meaningful long-term outperformance versus a broad market index. This outperformance is accomplished primarily by providing downside protection during periods of market decline, which is illustrated in Figure 2.
Figures 1 and 2 also show that active targeted volatility strategies have also provided meaningful downside protection, volatility reduction and outperformance relative to a broad market index. However, the MSCI World and MSCI USA Minimum Volatility Indexes have outperformed their active counterparts, both cumulatively and during the majority of significant market sell-offs in the period from 2010 to 2020.
Figure 1. Risk and return characteristics for low volatility equity indexes and their active targeted low volatility counterparts
Source: MercerInsight™. The chart shows the annualized total returns and standard deviations for each index shown over the 10-year period to December 31, 2019. Median manager returns are gross of fees and are based on the global and US targeted volatility equity universes maintained by Mercer in MercerInsight™. Past performance is no guarantee of future results.
Figure 2. Excess returns in up and down markets for low volatility equity indexes and their active targeted low volatility counterparts
Source: MercerInsight™. The chart shows relative gross of fees performance against the MSCI World Index, for the 10-year period to December 31, 2019, using total returns in US dollars. Past performance is no guarantee of future results.
The performance pattern seen in the decade to December 2019 persisted into the first quarter of 2020. The sell-off in equity markets saw low volatility outperform, as illustrated by the performance of the MSCI World Minimum Volatility Index (-15.4% over Q1 2020) compared to the MSCI World Index (-20.9%). Whilst there are similarities to previous shocks, COVID-19 is primarily a health crisis and the extent of the pandemic’s impact on the global economy has not been seen before. As such, its effect in certain areas of the market was not in line with conventional wisdom. Stocks in some traditionally defensive industries, such as airports and brewers lagged. In contrast, stocks in some (historically) higher beta areas of the market, such as bio-tech and IT stocks, were market leaders during Q1 2020.
While low volatility equities did not provide the same level of downside protection in the Q1 2020 sell-off compared to past crises, it did provide some as defensive sectors largely outperformed cyclical areas (Figure 3). Again, it was also a period in which active global targeted volatility strategies outperformed the broader market, but lagged the index.
Figure 3. MSCI World Index sector performance in Q1 2020
Source: MercerInsight™. The chart shows relative performance for each sector against the MSCI World Index, using total returns in US dollars.
In the period since 2010, most active targeted volatility strategies have delivered on their stated objectives compared to a broad market index, from both a risk and a return perspective. However, active management comes at a cost and there are passively managed alternatives available to investors, which have delivered favorable outcomes.
There are many risks inherent in low volatility equities (Figure 4), which are relevant for all investment approaches in this space. Active managers are able, and indeed expected, to manage these risks. In contrast, a low volatility index is unable to react to a changing environment or evolve in response to structural changes in the market. The decisions taken by active managers to mitigate the risks outlined in the table below are the principal reason why active strategies have underperformed the MSCI World Minimum Volatility Index over an extended period. While some of the risks discussed below can be prevalent in market cap weighted indexes at certain points in time, interest rate sensitivity and valuation risk, in particular, are embedded in low volatility indexes.
Figure 4. Inherent risks in low volatility equities
Active targeted volatility managers seek to construct diversified portfolios that limit excessive exposure to specific stocks, sectors, and countries, while managing the interest rate risk inherent in low volatility equities. Consequently, when compared to the MSCI World Minimum Volatility Index, active portfolios tend to exhibit notable biases towards value and small cap stocks, and a material underweight to the US market. These intended exposures largely explain the underperformance of active targeted volatility strategies. Figure 5 shows that active targeted volatility strategies with the largest US underweights, the most pronounced tilts towards value and away from large (and mega-cap) companies, were generally the weakest performers during the five-year period to December 2019.
Figure 5. Active low-volatility equity performance by style characteristic
Source: StyleAnalytics, MercerInsight™. Performance shown is for Mercer’s Global Equity Targeted Volatility Universe, and each manager’s performance is shown against the MSCI World Minimum Volatility Index. All performance is to December 31, 2019 and are gross of fees. Portfolio tilts are calculated based on holdings as at December 31, 2019. Past performance is no guarantee of future results.
Throughout this article, we have referred to the MSCI World Minimum Volatility index as a passive approach. However, this is somewhat misleading – we believe all non-market cap weighted indexes are active strategies in index form. The rules governing the construction of low volatility equity indexes require several active decisions that can have significant impacts on outcomes. In particular, the calculation of volatility, portfolio construction and the treatment of currency exposure vary enormously.
While market cap weighted indexes produced similar outcomes in the five-year period to June 30, 2020, the low volatility indexes differ much more substantially (see Figure 6). The MSCI World Minimum Volatility Index has delivered by far the best outcome over this period. We do not believe this is due to superior index construction. Rather the biases embedded in this specific index happen to have been rewarded over the last decade (although they are just as likely to be penalized over the next). The MSCI World Minimum Volatility Index does have the advantages of a long track record and widespread usage. However, it would seem misguided to position one index as the genuine passive approach.
Figure 6. Risk and return characteristics for various global and low volatility indexes
Source: MercerInsight™. The chart shows the annualized total returns and standard deviations for each index shown over the 5-year period to June 30, 2020. Past performance is no guarantee of future results.
Some of the risks associated with exposure to low volatility equity have become more pronounced in recent years. Interest rates have continued to fall, while global equity indexes have become more concentrated at the stock and country level, which has ultimately driven the underperformance of both small-cap and value stocks. However, low volatility equities should continue to form an integral component of an overall equity portfolio, which Mercer believes should comprise exposure to a diversified range of systematic return drivers.
Overall, although low volatility indexes have outperformed many active strategies in this space over recent years, Mercer continues to advocate an active approach. This is primarily due to our view that low volatility indexes carry inherent biases, which leave them vulnerable to poor performance in the future. In addition, active managers are able to integrate ESG risks into their investment process, which adds further appeal.
 Investors can achieve this exposure in a number of different ways: low volatility equities, quality-biased equities or variable beta strategies
 Notably: concentration risk, interest rate sensitivity, valuation risk and crowding risk
 Which we represent using the performance of the median manager in Mercer’s Global and US Equity Targeted Volatility universes
 To provide some perspective MSCI World Minimum Volatility outperformed MSCI World by approximately 10% during the global financial crisis (over the 17-month period to March 9, 2009) and approximately 25% during the dot.com bubble (over the 30-month period to October 9, 2002). Source: MercerInsight™.
 The median manager in Mercer’s Global Equity Targeted Volatility universe returned -18.9% (before fees), compared with -15.4% for the MSCI World Minimum Volatility Index, and -20.9% for the MSCI World Index for the three-month period to March 31, 2020. Source: MercerInsight™.
 For further analysis on the interest sensitivity of low volatility equities, see our 2018 paper Low Volatility Equities – Time to Leave the Party?. https://www.mercer.com/content/dam/mercer/attachments/private/nurture-cycle/gl-2018-wealth-low-volatility-equities-time-to-leave-the-party-mercer.pdf
 Five-year performance to 31 December 2019 has been used due to the limitations on data availability
 Country and sector limits for MSCI World Minimum Volatility are linked to the ‘parent’ market cap weighted index – MSCI World. As an example, the MSCI Minimum Volatility Index’s exposure to the US market (which has outperformed) has been significantly higher than active strategies and many of its index peers (e.g. it is close to double that of the MSCI Risk Weighted Index as at 30 June 2020).
 The five factors that we recommend clients maintain exposure to are: value, quality, momentum, size and low volatility. For further detail on Mercer’s views on balancing factor exposures, see our recent article: What do I do with my Factors? Building Robust Portfolios in Uncertain Times. https://www.mercer.com/our-thinking/what-do-i-do-with-my-factors.html