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Playing Defense: Comparing US Large Cap Volatility Strategies

Playing Defense: Comparing US Large Cap Volatility Strategies

Posted May 19, 2023 at 11:30 am
Norbert Veldhuizen
FTSE Russell

After a protracted period of calm, volatility returned to markets in 2022—and has proven it’s here to stay in 2023. Investors are now looking to position portfolios for a potentially bumpy road ahead, leading to renewed interest in defensive strategies. 

Low Volatility Factor (LVF) and Minimum Variance (Min Var) are two popular defensive strategies that are sometimes used interchangeably. However, they have very distinct objectives, construction methodologies, and investment outcomes.  

Persistent market turbulence 

Market fears were high in 2022, fueled by the triple threat of stubbornly high US inflation, the Fed’s relentless efforts to bring it under control by raising interest rates, and a rapidly deteriorating global economic outlook. The aftermath of the Russia-Ukraine war and China’s zero-coupon policy added to investor jitters. 

While virtually no global market segment escaped the turmoil of the past year, US large cap equities were dealt a particularly sharp blow. The Russell 1000 Index plummeted -19.1% in 2022, and the Russell 1000 Volatility Factor Index came within mere basis points of its all-time high.[1] 

The US equity market volatility has extended into 2023, as a series of US bank failures and recession fears triggered a massive flight from risk in March, keeping the Russell Volatility Factor Index at elevated levels. The risk-off environment continued into April, where defensive industries such as Consumer Staples and Healthcare were among the strongest performers. 

Two distinct ways to play defence 

As defensive industries have cycled into favor, the market turmoil has led many investors to seek a defensive stance in their broader US large-cap exposure. LVF and Min Var are two common approaches to this—but despite sharing defensive qualities, the strategies have distinctly different objectives and construction methodologies. 

LVF and Min Var are both defensive strategies in that they use volatility metrics to build portfolios that exhibit lower volatility than the market-cap weighted benchmark. However, the primary objective of LVF strategies is to enhance return relative to the benchmark, while Min Var strategies aim to reduce total portfolio volatility.

LVF strategies seek to capture the historical premium associated with the low volatility effect,[2] thereby offering the potential for enhanced return. As such, they’re built to tilt away from the benchmark by overweighting less volatile stocks. By contrast, Min Var strategies consider both volatility and correlation between stocks, and then optimize the portfolio with the objective of minimizing total volatility.

Comparing two defensive strategies

Different objectives drive different outcomes 

Differing objectives and construction methodologies have resulted in considerably different risk and return outcomes. As shown, over the past 20 years, the Russell 1000 Minimum Variance Index has achieved its primary objective of volatility reduction relative to the Russell 1000 Index.

Volatility reduction vs the Russell 1000 Index

While the Russell Low Volatility Factor Index also offered volatility reduction, it was generally to a lesser extent—particularly at times of heightened market turbulence, such as during the 2008 Global Financial Crisis (GFC), and the 2020 onset of the pandemic. 

Volatility calculation methodology matters 

The two index methodologies also differ with respect to how they calculate volatility when screening potential constituent stocks—and this can have a material impact on performance outcomes. While the Min Var index uses two years of daily returns observations to calculate a stock’s standard deviation, the LVF index uses five years of weekly returns. As such, the Min Var index captures more market momentum while the LVF Index’s less frequent observations over a longer period make for a smoother ride.  

Two types of shelter from the storm 

The current macroeconomic regime has investors sharpening their focus on controlling portfolio risk, but there can be considerable confusion when it comes to discerning between popular defensive strategies. While LVF and Min Var strategies can both be described as defensive, their varied objectives and composition make them distinctly different approaches to defensive positioning. 

As LVF seeks return enhancement through its exposure to the Low Volatility Factor, it can be considered a standard factor investment approach that may be best combined with other return-enhancing factor strategies. Min Var, however, continues to meet its objective of reducing portfolio volatility—demonstrating its potential to offer protection from adverse market shocks.

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[1] Source: Eikon as of April 25, 2023

[2] Source: Haugen, R., and J. Heins. “On the Evidence Supporting the Existence of Risk Premiums in the Capital Market”, Wisconsin Working Paper, 1972. (SRN: https://ssrn.com/abstract=1783797)


Originally Posted May 18, 2023 – Playing defense: comparing US large cap volatility strategies

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