What Is Missing in Common Minimum Volatility Strategies? The Ignored Impact of Currency Risk

Published in The Journal of Index Investing, Fall 2017.

Executive summary

Global minimum-volatility products can look interchangeable, but the currency assumptions baked into risk measurement are often invisible to asset owners and can undermine the investment rationale. Volatility and correlation should be measured in the investor's home currency, and adjusted if returns are hedged; using a USD risk model for a non-US investor produces a different portfolio with higher realized volatility than a home-currency model would.

The dominant effect is home bias: minimum-variance construction naturally overweights the home country when risk is measured in that currency. Many index methodologies use USD risk models, exclude the home country, or cap country weights near cap-weight benchmarks, which strips out the home bias and pushes products toward a US-heavy look. A secondary benefit is that investors who deviate from the common USD model may face less crowding in popular low-volatility names.

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