The Low Volatility Trade — Evening Brief – 10.29.24

The turbulent third quarter, characterized by heightened geopolitical uncertainty and market apprehensions regarding a potential U.S. economic hard landing, has revitalized low volatility portfolios.

The MSCI World Min Vol Index, a gauge of low volatility investing, experienced a significant recovery in July and August as investors attempted to safeguard their portfolios against increasing concerns. This rebound follows its most significant decrease since 1988, influenced by a prior pro-risk environment and concentrated returns. The latest rally has reduced the index’s total drawdown to 41.7%.

The Federal Reserve’s 50 basis point interest rate cut last month is expected to be followed by additional cuts (there is a 96% probability of a quarter-point move at the November 7 meeting followed by a 71% chance of another quarter-point cut at the December 18 meeting), potentially boosting low volatility strategies.

Historically, reductions in interest rates have indicated a transition to a ‘risk-off’ environment, wherein investors adopt a more cautious stance and choose safer assets. In these periods, low volatility portfolios typically outperform, according to investment manager Man Group. When 3-month U.S. Treasury yields decrease by more than five basis points, the MSCI World Minimum Volatility Index outpaces the broader MSCI World Index by an average of 42 basis points each month, the firm added.

Conversely, when short-term U.S. Treasury yields increase by over five basis points, the Minimum Volatility Index generally underperforms, with an average return of -0.22%. In stable rate scenarios, the index underperforms, but by a lesser margin of 17 basis points. Man Group observed that lower interest rates are generally more advantageous for low volatility portfolios.

These portfolios aim to mitigate downside risk by concentrating on lower-risk stocks, frequently outperforming in economic downturns as investors pursue safety. Man Group observed that the Minimum Volatility Index outperformed the broader market by 2.6% and 3.3%, respectively, during substantial interest rate cuts in January 2008 and March 2020. This underscores their resilience in economic duress.

In September, markets interpreted the Federal Reserve’s actions with optimism, anticipating a soft economic landing despite the negative news. This was a notable departure from the prevailing pattern. Nevertheless, low volatility strategies will reemerge if economic conditions worsen.