RiskTech Forum

MSCI: Managing Risks Beyond Volatility

Posted: 1 October 2017  |  Source: MSCI

Investors use low volatility strategies for two main reasons: to reduce the risk of their portfolio (and by doing so improve risk-adjusted returns) and to benefit from the low volatility premium. These two characteristics have made low volatility strategies increasingly popular with equity investors.

Several articles describe the historical performance of low volatility strategies and discuss potential explanations behind the low volatility premium, for example, Haugen and Baker [1991]; Ang et al. [2006]; Baker, Bradley, and Wurgler [2011]; Frazzini and Pedersen [2014]; Ang [2014]; and Muijsson, Fishwick, and Satchell [2015]. In a recent paper (Alighanbari, Doole, and Shankar [2016]), the authors focus on practical implementation issues and discuss the benefits of using a fundamental factor model and a controlled optimization process in the design of investable minimum volatility strategies.

Well-designed minimum volatility strategies seek to reduce overall portfolio volatility, which is an important dimension of risk. Minimum volatility strategies also tend to improve other key risk measures for institutional investors. For instance, in Downing et al. [2015], the authors show that a minimum volatility strategy’s capabilities in mitigating tail risk is in line with strategies that directly target tail risk (minimum CVaR). They attribute this finding to the use of factor models in the minimum volatility strategy and the high level of information that is embedded in the factor models employed. Moreover, Scherer [2009] has highlighted the problems in handling explicit CVaR optimization compared with minimizing volatility (estimation error, approximation error, systematic momentum exposure).

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