The TE of minimum volatility strategies has historically tended to increase in periods of market drawdowns and volatility. This is due to the low beta of minimum volatility strategies, or their allocation to stocks deemed to incur fewer price swings. This low beta approach seeks to be less sensitive to market movement and have materially lower downside capture. The aim is to create favorable TE for investors and outperform the drawdown of the broader market. For investors who are TE-sensitive, this can pose a conundrum. Yet focusing solely on tracking error and sector constraints may result in an incomplete picture and lead to sub-optimal outcomes.
The Natixis Seeyond International Minimum Volatility ETF1 (MVIN) is an actively-managed strategy designed to deliver international diversification with less volatility. Since its launch in October 2016, MVIN has not exhibited a consistently higher tracking error than comparable passively-managed, constrained approaches. As the chart below depicts, MVIN has demonstrated a 1-year rolling tracking error comparable to that of a passively implemented ETF strategy based on the MSCI EAFE Minimum Volatility Index. Unlike the active investment selection and management approach in MVIN, the index-based strategy follows a semi-annual rebalancing schedule and a security selection approach that is constrained at both the country and sector level relative to the MSCI EAFE Index.2 Click here for standard performance.
MVIN vs MSCI EAFE Inex - 1 Yr Rolling Performance
Source: Morningstar as of 3/1/2020
Seeyond believes that reducing absolute risk and protecting portfolios against market drawdowns can require high and/or varying tracking error. In fact, we believe a strategy designed to reduce risk should move away from the benchmark as necessary, diverging from the beta-risk that can influence market-cap weighted indexes, high-beta managers, and fundamental managers. It follows that reducing absolute risk and protecting against market drawdowns implies allocating to strategies with the potential to exhibit high and varying tracking error over time. What investors should remain mindful of is whether or not such strategies are risk-focused.
Tracking Error Can Measure Outperformance
Seeyond believes that minimum volatility strategies need tracking error as they seek to outperform in risk-off environments. Unlike traditional equity strategies, minimum volatility strategies combine the market directionality of equity strategies with features of liquid alternative strategies and therefore need to be evaluated using a hybrid approach. In particular, tracking error which is typically viewed as a risk metric may not accurately assess the risk exhibited by those strategies. In fact, for traditional equity strategies, tracking error during upside market movements is viewed positively as it exemplifies the “alpha” component of return, which active managers seek to generate. On the downside, tracking error is viewed negatively as it generally signifies losses beyond those of capitalization weighted indexes. With minimum volatility strategies, that down market tracking error is entirely different. In fact, TE generated on the downside is directly correlated to the natural outperformance of these strategies which is generated from their lower sensitivity to market movements, or low beta. Similar to liquid alternative strategies, low beta provides a natural differentiation from the market, which can help preserve capital in periods of market weakness.
Seeyond MVIN: Historical Performance
As exhibited in the chart above, MVIN tracking error has shown to be sensitive to changing market environments. In particular, we believe we can make the following observations:
- As markets increased sharply in FY2017 and FY2019, MVIN’s TE remained constant. It delivered competitive performance with market-cap weighted indices through a combination of beta and alpha return.
- As markets declined sharply in FY2018 – and between late-February and mid-March 2020 –MVIN’s TE increased. This was due to “winning by not losing,” or creating greater “positive” tracking error while protecting capital through low beta exposure.
- During periods of steady/sideways market conditions, we observe tracking error declining. This reflects MVIN’s ability to keep up with equity markets in less-volatile environments.
In addition to low beta creating natural tracking error, we believe diversification is important within a portfolio construction framework. In fact, Seeyond believes that in periods of market weakness, the ability of a strategy to diversify away from other factor exposures which may create additional tracking error can be essential to preserving capital. As the table below shows, we can observe that the low volatility factor outperformed in environments of heightened systemic risk between 1999 and 2019, which are denoted by the years in red.
Min Vol vs. MSCI EAFE Index: 1999 – 2019
Past performance is no guarantee of future results.
Seeyond believes that minimum volatility is best measured by its contribution to the portfolio in terms of Sharpe ratio, which measures the risk-adjusted performance of an investment compared to a hypothetical risk-free asset.3 Investors looking to outperform the broad market while reducing absolute risk may want to consider enhancing their benchmarking approach by considering a low volatility index strategy like MVIN.
2 The MSCI EAFE Index is a stock market index that is designed to measure the equity market performance of developed markets outside of the US & Canada. It is maintained by MSCI Inc., a provider of investment decision support tools; the EAFE acronym stands for Europe, Australasia and Far East.
3 The Sharpe ratio is defined as the difference between the returns of an investment and a risk-free return, divided by the standard deviation of the investment.
Gross Expense Ratio: 1.52% | Net Expense Ratio (Contractual): 0.55% | Contractual Expiration Date: 4/30/21 | Inception Date: 10/25/16
Performance data shown represents past performance and is no guarantee of, and not necessarily indicative of future results. Total return and value will vary and you may have a gain or loss when shares are sold. Current performance may be lower or higher than quoted. Returns include changes in share price and reinvestment of dividends and capital gains, if any.
After-tax returns are calculated based on NAV using the highest individual federal income tax rate and does not reflect the impact of state and local taxes. Actual after-tax returns will depend on an investor's tax situation and may be different from those shown. After-tax would not be relevant to shares owned through a tax-deferred account such as an IRA or 401(k) plan. The return After Taxes on Distributions and Sales of Fund Shares may exceed the Return Before Taxes due to an assumed tax benefit from the pass-through of foreign tax credits and/or from losses on a sale of Fund shares at the end of the measurement period.
Market returns are based upon the midpoint of the bid/ask spread at 4:00 p.m. Eastern time, when the NAV is normally calculated for ETFs. Your returns may differ if you traded shares at other times.
Alpha is used in finance as a measure of performance, indicating when a strategy, trader, or portfolio manager has managed to beat the market return over some period.
Beta is a measure of the volatility, or systematic risk, of a security or portfolio, in comparison to the market as a whole.
Diversification does not ensure a profit or guarantee against loss.
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