Lazard points to problems in low volatility index construction

The way some low volatility equity indices are structured creates some significant risks in the growing number of minimum variance passive funds, says Lazard Asset Management.

Active managers are pointing out potential pitfalls of their passive cousins at a time that index groups from Russell to MSCI to Standard & Poor’s are all constructing indices consciously focused on low volatility stocks – whether this part, or all, of their strategy.

The active managers highlight unusually large sector, currency and geographic risks – the same kinds of dangers active managers of minimum variance portfolios use their risk assessment to avoid.

They say investors should understand that constructing a good minimum variance portfolio requires active risk assessment in areas such as finding positions, or markets, that offset one another’s risk, position sizing and limiting some exposures, which cannot simply be built into Index construction rules.

Susanne Willumsen (pictured), one of two lead managers of LAM’s Lazard Global Controlled Volatility fund, says: “A low volatility portfolio is not just buying stocks that are low volatility. It is about offsetting risk as well.”

She notes low volatile stocks do typically perform better than higher volatility shares over long time periods, while consuming less of an equity risk budget important for those subjected to Solvency II strictures, but those using passive products to gain exposure may unknowingly be taking on higher risks.

She points first to the danger of disproportionate exposure to US markets in MSCI’s low volatility product, because it takes the US dollar and not local currencies, as the basis for its risk modelling calculations.

As a result, “anything outside the US appears riskier, even if it is the same stock listed somewhere else, so you will get a home bias.” North America recently represented about 62.8% of the MSCI World Minimum Volatility Index – “a big bet on the US economy, even though it has been the best place to be for the past five years, hence its low risk,” Willumsen says.



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