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The Sky is the Limit: Harvesting More from a Minimum Volatility Strategy?

Recent years have seen burgeoning popularity of minimum volatility products in the marketplace, which begs a practically important question: what is the limit, if any, of the performance improvement of such strategy? One would think the most direct approach is more accurate risk forecast since it is the only key input to minimum volatility strategy. However, through the lens of perfect foresight, the author shows that the potential is rather limited even with reasonably better estimates on top of the already sophisticated commercial risk models. A more impactful alternative is introducing a small amount of alpha to the objective function. A minimum volatility strategy augmented with overly simple alpha model is found to perform almost as well as the base case with fair amount of perfect foresight of risk. Overall the results imply that while traditional minimum volatility strategy suits investors who are sensitive to short-term drawdowns, the alpha-augmented version is surely worth considering for investors seeking longer term risk-adjusted returns.