Many European investors who bought low volatility equity funds were caught by surprise: the volatility generated by such funds has been almost as high as the market volatility. Nomura’s researchers in Europe confirm. In December 2013 they released a research note highlighting that most low volatility equity products have recently been failing to reduce risk. What is going on?
Let us consider the Parvest Equity World Low Volatility fund and estimate the volatility of monthly returns since inception at the start of April 2011 until the end of March 2014. If we use USD returns we find an annualised volatility of 11.1% which is 21% lower than the MSCI World index volatility at 14.1%. The beta of the fund is 0.75 and the correlation with the index is +95%. This is all in line with our expectations.
Using EUR returns the volatility of the fund is much lower at only 8% in the same period. However, if compared with the volatility of the MSCI World index, at 9%, that is just 11% reduction in volatility. The beta of the fund is 0.73 when measured in EUR and the correlation of the returns of the fund with those of the index is lower in EUR at only +83%.
The conclusion is that the US and the European investor experienced different volatility reduction and correlation with the index. In fact, that is not surprising and can be explained by the impact of FX. As of recently, the returns of the MSCI World index in USD have been extremely negatively correlated with the returns to the USDEUR. The correlation in the last three years to end of March 2013 was -75%. This explains why the volatility of the MSCI World index in EUR has been so much lower than in USD.
In the last three years, EMU stocks have been much more volatile than US stocks. The market capitalisation MSCI USD index generated only 13% annualised volatility of USD returns compared to 23% for the MSCI EMU index. Global equity portfolios invested in low volatility stocks have in generally been tilted away from EMU stocks. It happens that low volatility US stocks exhibited a much lower correlation with the USDEUR than US stocks in general. The MSCI USA Minimum Volatility index has been only -48% correlated with USDEUR returns compared with a correlation of -67% for the USDEUR with the MSCI USA (Large Mid) index returns in USD, and -83% for the USDEUR with the MSCI EMU (Large Mid) index returns in USD.
That explains why global equity portfolios invested in low volatility stocks have in general shown a less negative correlation with USDEUR and thus been less exposed to the diversification effect from the exposure to the currency, with the end result being less reduction in volatility for the EUR investor.
If the currency exposures in the fund and MSCI Index had been hedged, the volatility experienced by US and European investor would have been the same. But hedging currencies is not a good solution because most investors do not use hedged indices as benchmarks.
Another possibility is to create a bias in the base currency to reduce FX exposures. MSCI went this way and created different global indices for different base currencies. There is not just one MSCI World Minimum Volatility index but many and each comes with strong biases towards the stocks in the base currency. The main issue is that the performances of the different underlying portfolios in each index can be substantially different after translating them into a common currency.
We believe in building an optimally diversified portfolio invested in low volatility equities from different currencies. Our research demonstrated the superiority of this solution. The recent strong correlation between equity returns and EURUSD returns is not the norm.
Our research carried out in 2010 showed that in the long-term the impact of FX on the volatility of the low equities portfolios is small. A unique portfolio invested in low volatility stocks not biased towards any particular currency is more diversified and serves equally well all investors irrespectively of their base currency. Nevertheless, in the short-term, the reduction of volatility may indeed be smaller than expected for some investors when FX plays an important role, in particular when correlations between FX and equities are very strong.
 Inigo Fraser Jenkins et al., Global Quantitative Research 2014 Outlook, Nomura Global Markets Research, 1st December 2013
 ISIN code of I share (EUR): LU0823418115