The MSCI World Minimum Volatility index has had a very poor run of performance recently. In absolute terms the index generated a cumulative performance of minus 5.7% between 1 July 2016 and 30 November 2016. This underperformance has sparked much comment and suggestions that a bubble in low-volatility equities is now bursting. Over the same period the MSCI World index generated a positive return of 4.3%, so just what is going on?

In our view, the poor performance of the MSCI World Minimum Volatility index and other minimum variance strategies are primarily a function of the recent rise in US bond yields. We can demonstrate that low-volatility strategies whose exposure to interest rates has been neutralised through sector diversification have significantly outperformed minimum variance strategies.

#### Why is minimum variance a poor strategy for low-volatility investing?

Two years ago we published empirical evidence demonstrating that the MSCI World Minimum Volatility Index had a significant negative exposure to interest rate movements and would therefore be vulnerable to rising interest rates. Although MSCI have since changed the strategy behind the index, and therefore the return history for this index has been altered, the conclusions we came to back then have lost nothing of their pertinence.

The negative impact resulting from the exposure to interest rates movements, common to minimum variance strategies in general and to the MSCI World Minimum Volatility Index in particular, is the consequence of a structural overweight in interest rate sensitive sectors such as utilities and telecommunications. There are two explanations for the interest rate sensitivity of stocks in these sectors:

- Utility and telecommunication companies are more sensitive to movements in interest rates than other sectors because they have higher borrowing needs,
- Historically, debt issued by utility and telecommunication companies has been high-yielding. But rising interest rates makes investing in bonds increasingly attractive relative to equity investments in such sectors.

The over-exposure of minimum variance strategies to interest rate sensitive stocks is due to the fact that such stocks tend to behave much more like bonds than equities. They therefore tend to have the lowest levels of market beta. Minimum variance simply allocates the largest portfolio weights to stocks with the lowest beta.

#### Low-risk investment without interest rate sensitivity

At the same time, our previous research demonstrated that the neutralisation of the exposure to changes in interest rates in low-volatility equity investing can be efficiently achieved with a sector diversified strategy that avoids concentration in interest rate sensitive sectors. Indeed, a sector-neutral low-volatility strategy can be employed not only to significantly reduce exposure to interest rate changes but also to capture more efficiently the low-volatility effect in equities. This was very clearly highlighted in the research we published two years ago.

Table 1 shows the Jensen alpha for two low-volatility equity strategies under different interest-rate regimes. One strategy is the MSCI World Minimum Volatility index (USD). The algorithm used by MSCI attempts to remove factor exposures other than low risk by imposing numerous allocation and factor constraints relative to the MSCI World index. The second strategy is a Sector-Neutral Low-Risk strategy, which is long-only and invests only in the least volatile stocks of each sector in the MSCI World index. This strategy uses a tracking error control as an alternative means of removing factor exposures relative to the market capitalisation portfolio.

#### Exhibit 1: Jensen alpha generated by the MSCI Minimum Volatility index and a Sector-Neutral Low-Risk strategy, conditional on US interest-rate monthly changes. Total returns are gross of management fees, transaction costs and market impact. Jan 1995 to Nov 2016*

Source: MSCI, Bloomberg, Factset and BNP Paribas Asset Management

These empirical results for the period between January 1995 and November 2016 demonstrate the independence of the regression coefficient (Jensen alpha) of the Sector-Neutral Low-Risk strategy to interest-rate changes. This is in contrast to the MSCI World Minimum Volatility index which is very exposed to changes in interest rates. As a consequence, the overall Jensen alpha of the MSCI Minimum Volatility index is strongly dependent on changes in interest rates during the period analysed. This cannot be said to be the case for the Sector-Neutral Low-Risk strategy.

#### Sensitivity to changes in interest rates in the recent low interest rate environment

In the past six years, the Sector-Neutral Low Risk strategy continued to perform remarkably well irrespective of changes in interest rates, with the volatility of the Jensen Alpha Volatility at only 3.4% annualised. However, during the same period, the negative impact of the MSCI World Minimum Volatility Index’s exposure to changes in interest rates has dramatically increased, with a much larger negative alpha in periods of rising interest rates, and a much higher positive alpha during periods when interest rates fell. The higher Jensen alpha volatility increased to 5.7% and a significant negative correlation of the Jensen alpha with the yield changes at -54% was observed.

#### Exhibit 2: Alpha generated by the MSCI World Minimum Volatility index and a Sector-Neutral Low Risk strategy in the past six years, conditional on US interest rate monthly changes. Total returns are gross of management fees, transaction costs and market impact. Dec 2010 to Nov 2016*

Source: MSCI, Bloomberg, Factset and BNP Paribas Asset Management

In our view the increased sensitivity to changes in interest rates observed for the MSCI Minimum Volatility index is understandable. The bond yields directly influence the valuation of stocks in sectors such as Utilities and Telecommunications to which minimum variance strategies are overexposed. The greater sensitivity to interest rates can be explained by the higher bond duration (price sensitivity for a unit change in yield) in a low interest rate environment, especially for the long-maturity bonds.

#### Interest rates are rising! Help! Get me out of minimum variance!

Since bond yields in the US started rising in late spring 2016, the MSCI World Minimum Volatility Index started, as anticipated, to underperform the Sector-Neutral Low-Risk strategy. The increased duration of the MSCI strategy, due to very low interest rate environment, amplified the level of underperformance relative to the Sector-Neutral Low-Risk strategy. Over the last 5 months this underperformance reached an eye-watering 6.7%.

#### Exhibit 3: The level of US 5-year bond yields (bottom graph) and the total return price index for the MSCI World Minimum Volatility index and the Sector-Neutral Low Risk strategy (top graph). Total returns are gross of management fees, transaction costs and market impact. Jun 2016 to Nov 2016*

Source: MSCI, Bloomberg, Factset and BNP Paribas Asset Management

**Table 3: Cumulated returns generated by the MSCI World Minimum Volatility index compared to those from a Sector-Neutral Low Risk strategy. Jun 2016 to Nov 2016* **

Source: MSCI, Bloomberg, Factset and BNP Paribas Asset Management

#### Still time to escape

Careful analysis of minimum variance equity strategies shows that they are negatively exposed to interest rate changes. Such negative exposure should be magnified during periods of low interest rates because the duration of low risk interest-rate-sensitive stocks increases. In our view, this negative exposure to interest rates is sufficient to explain both the recent underperformance of minimum variance strategies such as the MSCI Minimum Volatility Index and, by the same token, the resilience of sector diversified low-volatility strategies in recent months.

Paying adequate attention to hidden exposures in factor investing strategies such as low-volatility equities is in the current rising interest rate environment, of extreme importance. With interest rates at such low levels in most developed countries and anticipations of an acceleration in the pace of interest rate rises, e.g. in the US, we strongly recommend investors to switch out of minimum variance equities into sector-diversified low-risk strategies.

Please note that this article may contain technical language. For this reason, it is not recommended to readers without professional investment experience.

This article was written by Xiao Lu and Raul Leote de Carvalho.

Great work Raul.