This decomposition explains why the min vol portfolio does better, on average, than the market in terms of returns per unit of risk. If the market is up, say, 10% then the low beta portfolio will be up 6.2% just from its exposure to the market — plus 2.75% of additional return. That results in a total return of 8.95% for an “upside capture” of 89%. On the other hand, if the market is down 10% then the low-beta portfolio will be down 6.2% from its exposure to the market — plus 2.75% of additional return. That results in a total return of 3.45%, and a “downside capture” of 34%. On average, there is better upside capture than downside capture.
The key point is that these asymmetric “capture ratios” arise not because of compounding but simply because the min vol portfolio provides additional return on top of exposure to the market. This is the same thing that happens with any active fund that is successful in delivering alpha on top of its benchmark.
Take the case of a hypothetical manager who is benchmarked to the S&P 500 and delivers 2% alpha on top the S&P 500 returns. If the S&P 500 is up 10% then such a manager would have a return of 12%. If the market is down 10% the manager would be down 8%, thus providing 120% upside capture and 80% downside capture — the same asymmetric capture ratios as a min vol portfolio.
In the end, investors who are considering minimum volatility as part of their portfolio need to be comfortable not with the capture ratios or the impact of compounding, but with the origin of that additional return and its explanations, both behavioral as well as induced by arbitrage constraints in the marketplace.
[1] This is a straightforward computation. I have taken the monthly returns of the low-beta portfolio introduced as a simple experiment in my previous post and looked at how closely they can be matched by a combination of the market returns and a constant additional return. This the same computation used to get the beta of an individual stock in the traditional CAPM setup. The CAPM or capital asset pricing model posits that the performance of an asset or portfolio can be explained by a linear combination of the performance of the market (i.e. its exposure or “beta”) and an additional component that is specific to each asset. Standard theory is that the additional component specific to each asset should be, on average, zero. Assets or portfolios that have, over time, returns in addition to their exposure to the market that are larger than zero are generally described as having “alpha.”
Daniel Morillo, PhD, is the iShares Head of Investment Research.