Views From the Floor - Market Calm Creates Perfect Storm for Low Vol

Risk-on sentiment and mega-cap returns are causing historic underperformance for low-volatility portfolios. Could this be due for a reversal?

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While stock market indices continue their slow grind higher in July, the Vix index, widely seen as the market’s fear gauge, has continued its trend lower. This calm in markets has created the perfect storm for one area of the investment landscape, namely, low-volatility portfolios, interrupting their recovery from their historically large relative underperformance during the post-Covid market rebound that had started in 2022. The market environment of the second quarter became increasingly challenging for low-volatility investing, with the pro-risk sentiment and market dominance by largecap high-beta names both creating significant headwinds. As a result, the drawdown in the MSCI World Min Vol Index (relative to the standard index) has reached an extreme level that is only comparable to the DotCom tech bubble and the post-Covid market risk rally, meaning that the Min Vol Index has given back almost all of its gains from the 2022 recovery, as shown in Figure 1.

Figure 1. Low Volatility’s Historic Relative Underperformance

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Source: Man Numeric, Bloomberg.

From a factor perspective, while we have not recently witnessed as brutal a risk rally as in January, the narrative of the market in the past few months has been characteristically risk-seeking, as demonstrated by the outperformance of Growth, Leverage, Beta and Volatility factors. In contrast, Quality concepts (Investment Quality, Profitability) were generally negative. In a nutshell, the market continues to reward frothy names, similar to what was observed at the beginning of the year.

Apart from the factor backdrop being unfavourable to low-volatility portfolios, extreme levels of market concentration delivered another blow. While the market index overall seemed strong, the number of individual names outperforming was in fact quite limited, indicating that the recent market rally has been on low breadth.

To illustrate this point, the cap-weighted MSCI World Index has meaningfully outperformed its equal-weighted counterpart since 2018. Although this trend temporarily reversed in 2022, it has revived this year, with mega-cap stocks once again starting to dominate the market, especially in the US (Figure 2). Such concentrated market conditions generally hurt low-volatility portfolios which tend to align more closely with the equal-weighted index due to risk diversification considerations.

Figure 2. MSCI World Index Performance - Cap-Weighted Outperforming Equal-Weighted

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Source: Man Numeric, Bloomberg.

In addition, those stocks leading the market during the past quarter tended to have a pro-risk profile and were positively exposed to the AI hype. As written in our recent viewpoint, Animal Spirits Latch on to AI Theme, all of the top five contributors to returns for the MSCI World Index over the past quarter were high-beta technology stocks that are typically not owned by low-volatility portfolios. Not owning these five stocks would have cost a low-volatility portfolio approximately 3% of performance relative to the broad index. Such periods of extreme relative underperformance for low-volatility have been rare in its long-term history, and low-volatility may well be due for some mean reversion once the eerie calm of markets breaks.


With contributions from Valerie Xiang (Associate Portfolio Manager, Man Numeric).

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