This approach is unique in that it is top-down: securities are selected in concert with one another to create a portfolio-level effect. The question is, does a portfolio with minimum volatility necessarily imply a tilt to a low volatility effect? Is it not possible to construct a minimum volatility portfolio by combining high risk, but negatively correlated, securities?
As it turns out, when you are considering a non-trivial example, the answer is largely “no.” In fact, De Carvalho, Lu, and Moulin (2012) find that the key factor exposures in a minimum variance portfolio is low beta and low residual volatility stocks. So despite a more opaque construction methodology, USMV should tap into the same low volatility factor as USMV and LGLV.
Conclusion
Which approach reigns supreme?
It depends on your views relating to sector and security concentration. Each approach introduces its own risks:
- SPLV’s approach can lead to large sector concentration bets
- LGLV, though constrained from a sector perspective, may introduce large security bets through its inverse-variance weighting scheme
- USMV sits between the two, with greater sector constraints than SPLV but less than LGLV, and potentially more concentrated holdings than SPLV but less than LGLV
The question of which approach to employ will largely rest upon which risks investors feel comfortable taking.
The good news is that no matter which approach they take, all three construction methods have a solid grounding in academic evidence that supports their exposure to the low volatility anomaly.
Disclosure: Newfound currently utilizes USMV within its U.S. Factor Defensive Equity strategy.
References
Asness, C.S., A. Frazzini, and L.H. Pedersen. “Low-risk investing without industry bets.” Financial Analysts Journal, Vol. 70, No. 4 (2014), pp. 9-12.
De Carvalho, R.L., X. Lu, and P. Moulin. “Demystifying Equity Risk-Based Strategies: A Simple Alpha plus Beta Description.” The Journal of Portfolio Management, Vol. 38, No. 3 (2012), pp. 56- 70.
De Carvalho, R.L., M. Zakaria, X. Lu, and P. Moulin. “Low-risk anomaly everywhere: Evidence from equity sectors.” SSRN No. 2527852, 2014.
Frazzini, A., and L.H. Pedersen. “Betting against Beta.” Journal of Financial Economics, Vol. 111, No. 1 (2014), pp. 1-25.
Haugen, R.A., and A.J. Heins. “On the Evidence Supporting the Existence of Risk Premiums in the Capital Markets.” Working paper, SSRN No. 1783797, 1972.