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SSgA CAPITAL INSIGHTS THE EXCHANGE

What are the Performance Drivers of the Global Managed Volatility Strategy?

The Modern Portfolio Theory developed by Harry Markowitz

and William Sharpe explored the concept of efficient portfolios.

An efficient portfolio is one which delivers the maximum

expected return for a defined level of risk. Under the theory, the

market capitalization portfolio—which is held to be approximated

by the MSCI World index—is efficient. A portfolio which has

the minimum expected volatility is also supposed to be efficient

since no portfolio should have a lower risk. According to the

theory, and to common sense, the minimum volatility portfolio

should have a lower volatility and a lower performance than the

market capitalization portfolio.

However and perhaps surprisingly, it appears that for the

past 13 years the minimum volatility portfolio has experienced

a consistent outperformance versus the market capitalization

portfolio. And this has been coupled with a consistent reduction

of risk (as expressed by volatility).

Does this performance come solely from the pure low-beta

characteristic of the strategy or is there any kind of contribution

coming from value or small-cap exposure? This piece explores

the performance drivers of this kind of strategy.

Implementing a Minimum Volatility Strategy

The concept of the theoretical minimum volatility can be practi-

cally implemented through strategies such as SSgA’s Global

Managed Volatility product, or through index provider strategies

such as the MSCI World Minimum Volatility Index or the STOXX

Global 1800 Minimum Variance Index. The SSgA Global

Managed Volatility strategy aims to create a 100% equity portfolio

within the MSCI World universe. It uses quadratic optimization

in order to produce the minimum volatility with the minimum set

of other constraints. To judge its performance, we will review the

strategy compared to its two natural benchmarks.

The first of these is the MSCI World strategy. This is the market

capitalization index and the efficient benchmark according

to Modern Portfolio Theory. The other is the Equi Weighted

strategy. This strategy gives equal weight to every stock of the

MSCI World population. It is readjusted back to equal weight

every quarter. Some consider this Equi Weighted strategy to be

the most appropriate benchmark because it gives the universe

of possible investment without taking into account information

such as market capitalization. As such, it could be considered

as perfectly neutral.

Chart 1 shows the performance and risks (volatility) of the

3 strategies. The 1998–2011 period is used in order to have at

least the typical 10 years and to include the technology bubble.

The Global Managed Volatility strategy has experienced a strong

outperformance over the MSCI World, showing both an increase

in performance and a decrease in volatility. The decrease in

volatility was expected since the strategy has been designed to

minimize volatility. However, the outperformance would not be

expected according to theory. To understand this result more,

we analyse the sources of the outperformance below. The

Equi Weighted World strategy has experienced a comparable

magnitude of outperformance but with higher levels of volatility,

that is, with more risk.

by Frederic Jamet Head of Investments, SSgA France

Chart 1: Performance and Risk of the 3 StrategiesAnnualized Return (%)

Annualized Volatility (%)

Global Managed Volatility 7.96 10.71

Equi Weighted World 7.04 18.02

MSCI World 2.44 16.65

From 1998 to 2011, in USDSource: MSCI, SSgA

SSgA CAPITAL INSIGHTS | THE EXCHANGE

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The 3 Performance Factors—Market, Value and Small-cap

In his Capital Asset Pricing Model theory, or CAPM, William

Sharpe suggested that the performance of a portfolio arises

from a unique factor: the market factor, or beta. This concept

has since been extended by Eugene Fama and Kenneth

French, who suggested adding 2 other factors: the small-cap

factor and the value factor.

The Factor Calculation

We have computed the value and small-cap factors in a

straightforward way in order to follow the Fama and French

approach. (This computation was made specifically in order to

have the same systematic approach for value and small-cap

factors: this is not the standard MSCI computation.)

Each year the MSCI World is split into 2 halves that represent

each 50% of the MSCI World market cap. The high value stocks

are the 50% bottom Price/Book (P/B) whereas the low value

stocks are the 50% top P/B. The value factor is then the perfor-

mance of the bottom P/B stocks minus the performance of the

top P/B stocks. The small-cap factor represents the performance

of the 50% bottom market cap stocks minus the 50% large

market cap stocks. Each factor is recomputed every year.

The market factor is represented by the MSCI World index

minus the T-Bill 3 months USD (which represents the risk-free

rate i.e. the interest an investor would expect from an absolutely

risk-free investment over a period of time). The performances

and risks of the 3 factors are described below in Chart 2.

Historical returns represent the 1926–2009 performance of

comparable factors in the US market.

The market factor has produced a poor performance over the

period since the MSCI World has underperformed the risk-free

rate for the 13 year period we are assessing. Consequently,

any strategy that has been underexposed to the market—such

as Global Managed Volatility, or any blend of market-exposed

strategy and risk-free rate or fixed income—is likely to have

overperformed. It should be noted that this past 13 years of

underperformance for the MSCI World could be considered an

unusually bad performance, when compared to historical returns.

The value and small-cap factor have had a positive and material

outperformance for the past 13 years, more or less in line with

the long-term historical return.

Performance Drivers of the Global Managed Volatility Strategy

Chart 4 shows the factor exposures of each of the 3 strategies,

for the period 1998 to 2011.

Both the Global Managed Volatility strategy and the Equi

Weighted strategy have relatively comparable exposure.

They both have a significant positive exposure to the market,

value and small-cap factors. Both exhibit a monthly positive

alpha although not significantly different from zero. The Global

Managed Volatility strategy has a lower exposure to the market

factor, or beta; and the Equi Weighted strategy has a higher

exposure to the small-cap factor.

The value exposure of the Global Managed Volatility strategy

can be explained by the fact that a neglected stock has a

de-correlated behaviour. Neglected stocks probably have a

value bias because they are neglected, and will be overweighted

in the Global Managed Volatility strategy because they

are de-correlated.

Chart 2: MSCI World Performance and Risk Breakdown, 1998–2011

Annualized Return (%)

Annualized Volatility (%)

Historical Return (1926–2009) (%)

Market Factor -0.03 16.66 5.18

Value Factor 2.91 8.75 2.60

Small-cap Factor 5.01 6.87 5.00

From 1998 to 2011 in USDSource: MSCI, SSgA, Historical Charts from Dimson, Marsh, Staunton on 1926–2009 in USA

Chart 3: Relative Performance of the 3 Strategies and Component Factors

Source: MSCI, SSgA

— MSCI World— Value Factor

— Managed Volatility— Small Cap Factor

— Equal Weight

Performances

Cumulative Perfomances in (%)

0.5 Dec1998

2002 2006 2010 Dec2011

1.0

1.5

2.0

2.5

3.0

Chart 4: Exposure to the 3 Factors, 1998–2011Market

Exposure (%)Value

Exposure (%)Small-cap

Exposure (%)Alpha (%)

R2 (%)

Global Managed Volatility

49.5 16.4 27.5 0.3 73.6

Equi Weighted 100.1 13.0 53.6 0.1 98.1

MSCI World 100.0

From 1998 to 2011 in USD. All Charts significant at 95% level except the Alpha Charts which is not significantly different from zero.Source: MSCI, SSgA

SSgA CAPITAL INSIGHTS | THE EXCHANGE

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The small-cap exposure can be explained by the fact that any

strategy that is not market-cap weighted tends to select stocks

more frequently in the small-cap area, because small-cap

stocks are more numerous.

The variance of the strategies, or the source of the performance

and volatility are analysed in the Chart 5. Variance is considered

here as the square of the annualized volatility where volatility is

the standard deviation of the monthly rate of returns.

The major contributor to the total variance, i.e. the major driver

of the strategy, is the market factor. The outperformance of the

Global Managed Volatility strategy comes firstly because of the

low beta, or low exposure to the market factor. However a signif-

icant source of variance comes from the small-cap and value

factors, and from their combination.

In fact it seems that, according to the variance analysis, the value

added of the Equi Weighted strategy comes from the high over-

exposure and outperformance of the small-cap factor. The Global

Managed Volatility strategy seems more complex: its sources of

value added are more diversified amongst value and small-cap,

and a significant part of the variance remains unexplained.

Conclusion

As expected the Global Managed Volatility strategy has offered

a significant reduction in volatility during the part 13 years.

However, additionally, the strategy has significantly outper-

formed the MSCI World index.

The main driver of the strategy’s performance has been the

low exposure to the market or the exposure to a low beta factor,

and the mediocre performance of the market. These have

contributed 59% of the total variance.

However the Global Managed Volatility strategy is also signifi-

cantly exposed to value and small-cap factors. This exposure is a

structural part of the strategy. They have contributed 14% of the

total variance. It thus appears that the Global Managed Volatility

strategy offers not only a simple volatility reduction, but also a

larger and more diversified exposure to other risk premiums.

Chart 5: Variance from the 3 FactorsTotal

Variance (%)Variance

Explained (%)From Market

only (%)From Value and Small-cap

beyond Market (%)From Value

only (%)From Small-cap

only (%)

Global Managed Volatility 100.0 73.6 59.1 14.5 1.8 3.1

Equi Weighted 100.0 98.1 85.5 12.7 0.4 6.8

MSCI World 100.0 100.0 100.0

From 1998 to 2011 in USDSource: MSCI, SSgA

SSgA CAPITAL INSIGHTS | THE EXCHANGE

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SSgA Global Entities

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Web: www.ssga.com

The views expressed in this material are the views of Frederic Jamet through the period ended July 31, 2012 and are subject to change based on market and other conditions. The information provided does not constitute investment advice and it should not be relied on as such. All material has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Past performance is not a guarantee of future results.

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