Using a low-volatility approach to temper emerging market risk

Category: Global

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Low-volatility strategies are not new but they have gained traction in recent years as markets, both developed and emerging, have become increasingly volatile. Emerging markets especially tend to have higher levels of risk than others, but they have lured investors with the potential for higher returns. For example, the S&P Emerging Plus LargeMidCap and the MSCI Emerging Markets Index and have each provided annualised returns of about 14% over the past ten years but with an associated annualised risk of about 25%, as measured by standard deviation.

S&P Dow Jones Indices uses a simple, non-optimised framework to construct low-volatility indices. S&P Dow Jones Indices introduced the S&P BMI Emerging Markets Low Volatility Index in December 2011 to apply methodology similar to what’s behind the S&P 500 Low Volatility Index to emerging market equities. The S&P BMI Emerging Market Low Volatility Index comprises the 200 least-volatile stocks in the S&P Emerging Plus LargeMidCap, which consists of 1,067 stocks as of March 30, 2012. Volatility is measured as the standard deviation of price changes over the trailing 252 days. The universe of stocks is ranked by their volatility factor and the 200 least-volatile stocks are picked and weighted by the inverse of their volatility (i.e., less-volatile stocks are assigned higher weights). The index is rebalanced quarterly.

Lower risk does not have to mean lower returns

The S&P BMI Emerging Market Low Volatility Index has outperformed its underlying benchmark, the S&P Emerging Plus LargeMidCap, and the MSCI Emerging Market Index, over the past ten years while reducing annualised risk by about 32% (see Exhibit 1).

Achieving better returns without taking on a higher level of risk sounds counterintuitive but it has been well documented in academic studies. The S&P BMI Emerging Markets Low Volatility Index has had better annualised returns than those of the MSCI Emerging Markets Index and the S&P Emerging Plus LargeMidCap over the short, medium, and long term, and those higher returns have been achieved with a lower level of risk.

Performance shifts in bull and bear markets

The movements of the S&P BMI Emerging Market Low Volatility Index do not always mirror those of the underlying benchmark index. In extreme bull markets like the ones seen in 2009, the S&P BMI Emerging Market Low Volatility Index returns (46.4% in 2009) usually lagged those of the S&P Emerging Plus LargeMidCap (77.5% in 2009) and the MSCI Emerging Markets Index (79% in 2009). However, in extreme bear markets, the S&P BMI Emerging Market Low Volatility Index tended to outperform the underlying benchmark S&P Emerging Plus LargeMidCap and the MSCI Emerging Markets Index. In 2000 to 2002, the S&P BMI Emerging Low Volatility Index lost 12% while the S&P Emerging Plus LargeMidCap and the MSCI Emerging Markets Index both lost 36%. In relatively less extreme markets, the return of the index is usually close to the benchmarks.

Higher dividend yields

The S&P BMI Emerging Markets Low Volatility Index provides a higher yield than the underlying benchmark S&P Emerging Plus LargeMidCap and the MSCI Emerging Markets Index. As of March 30, 2012, the S&P BMI Emerging Markets Low Volatility Index had an YTD annual yield of 4.08% while the annual yields of the S&P Emerging Plus LargeMidCap and the MSCI Emerging Markets Index were 2.78% and 2.71%, respectively. Over the last five years, the yields have been consistently above the benchmark.

Conclusion

The S&P BMI Emerging Markets Low Volatility Index follows a simple, transparent methodology to significantly reduce volatility and deliver higher returns over underlying benchmarks. It provides investors who are seeking exposure to emerging markets but are concerned about volatility with an alternative that has provided similar or better returns at a significantly reduced level of risk. In addition, investors that currently have allocations in emerging markets can view this strategy as a means to try to reduce their overall portfolio risk without losing the returns.