Investment solutions based on popular smart beta indices have enjoyed tremendous success. These generic products, however, raise serious issues regarding their ability to efficiently harvest factor premiums.
This study1 by MSCI examined how their popular Minimum Volatility (MV) index could be modified in order to address various concerns. The authors show that concentration, sustainability, and valuation concerns can be mitigated by using appropriate but simple optimization constraints.
These results are consistent with our own experience with low volatility strategies. However, we wonder how many passive investors will be able to benefit from these insights, as long as these are not incorporated into the standard MSCI MV index, which is likely to remain the preferred choice for most investors.
The study also found that adding a ‘maximum diversification’ (MD) constraint to the MV index leads to a clear deterioration in performance, which is interesting given the popularity of MD strategies. The study showed that MD tilts the portfolio towards stocks with high stock-specific risks, and that this hurts performance, given the poor long-term performance characteristics of such stocks.
1 Alighanbari, Doole & Melas, ‘Managing Risks Beyond Volatility’, Journal of Index Investing, Vol. 8, No. 2, 2017, pp. 68-76.
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