Minimum volatility a draw for investors

An unforgiving economic and market environment is driving institutional investors to embrace minimum volatility strategies this year.

According to a spokesman for New York-based BlackRock Inc., assets under management for the exchange-traded fund industry leader's minimum volatility ETFs around the globe surged to $37 billion as of Sept. 1 from $20 billion at the start of 2016.

Whether that considerable pickup in flows threatens to short-circuit minimum volatility's charms by pushing component stocks into overvalued territory remains more of a consideration than an immediate threat, most observers said.

For now, “market conditions are helping to fuel the activity we're seeing in minimum volatility,” with the strategy's embedded downside protection “ticking the box” for an ever-wider range of big institutional investors, said Kevin Hardy, a managing director with BlackRock and head of the firm's Singapore office.

For example, for investors with policy benchmarks that require them to remain fully invested in equities, even as markets have begun to look toppish, minimum volatility offers them a way to stay committed to equities for the long term while lowering overall portfolio volatility, Mr. Hardy noted.

Meanwhile, for big insurance companies, with huge holdings of bonds offering next to nothing in the way of yields, adding minimum volatility in lieu of market-cap-weighted exposure can free up their risk budgets, allowing them to add higher-yielding credit in pursuit of better returns, he said.

“As we look, it's very, very clear that minimum volatility (is) the topic that investors are looking at,” with the fastest growth rate among BlackRock's various factor strategies, said Mr. Hardy.

From the end of 2014 through July 2016, BlackRock's minimum volatility business from Asia-Pacific clients — composed of institutional mandates and ETFs — jumped 69%, according to the spokesman.

In contrast to the similarities between most market-cap-weighted stock market indexes, industry veterans say considerable differences in the way minimum volatility indexes are structured make it more difficult to reach sweeping judgments on the valuation of portfolios now.

For example, comparing the S&P low volatility index with the MSCI low volatility index, it's “night and day in the way they're constructed,” noted Wai Lee, a senior portfolio manager and global head of quantitative investments with New York-based Neuberger Berman LLC.

“Everybody defines (minimum volatility) slightly differently,” which can lead to different answers on the topic of how pricey the factor appears now, agreed John McCareins, Hong Kong-based managing director Asia-Pacific with Northern Trust Asset Management.

Minimum volatility is more “fairly valued” than extremely expensive, relative to historical norms, but the challenge is to remain a strategic investor, refraining from buying and selling intracycle in order to get a return premium that's remained fairly consistent over the long term, Mr. McCareins said.

Still, by some estimates the market segment is already in lofty territory. Minimum volatility portfolios “are currently trading at a huge premium over the market,” said Harindra de Silva, president of Los Angeles-based Analytic Investors LLC, pegging their price-earnings ratio at 24, as compared to a market P/E of 18.

BlackRock's Mr. Hardy said minimum volatility valuations aren't looking overly pricey, and periodic rules-based rebalancing is designed to leave those portfolios positioned to do what investors expect them to do — lower the volatility of their broader portfolios.

On the question of crowding, Mr. Hardy said BlackRock's $110 billion book of smart-beta products — “probably the largest book in this space” — simply isn't that large, compared to the broader market. Even if that $110 billion were all in minimum volatility, the typical portfolio isn't so concentrated, with hundreds of stocks, leaving “ample space for more investors to be in this arena,” he said.

Investment consultants agree, for the most part, that there are no clear signs of imminent problems from high valuations, with caveats that the situation bears watching.

While Mercer looked into the valuation question earlier this year and concluded it “wasn't a significant issue at the moment,” it's still a risk that needs to be monitored, said Richard Dell, the London-based head of Mercer Investment Consulting's global equity boutique.

More than before, some attention needs to be paid as to whether assets are flowing into similar stocks, buoying valuations, he said.

James Price, a London-based senior investment consultant with Willis Towers Watson PLC, said minimum volatility should continue to be able to dampen volatility in institutional portfolios, but at a time when relatively strong investment gains are drawing interest to the strategy, his team remains skeptical that such outperformance will prove sustainable as more money continues to flow to the strategy.