Minimum Variance has its ‘day in the sun’

Inderpal Gujral, head of product at STOXX, has seen recent market volatility shining a bright light onto their range of Minimum Variance Indices, designed to reduce risk by attempting to minimise the variance (and thus volatility) of a portfolio.
STOXX offers two versions of their minimum variance indices: constrained and unconstrained. The range was launched more than six years ago but has seen its most popular period in the last two years, with assets managed globally against STOXX min var indices exceeding USD1 billion.

Gujral explains that minimum variance tends to perform well in a market environment that is witnessing volatility.

“The STOXX USA benchmark index had outperformed the min var version during the year by nearly 4 per cent over the summer. Now, the min var version is ahead of the benchmark by 4 per cent due to reversals in the stock markets over the recent six to eight weeks of slightly volatile returns, coming on the back of a 10-year bull run, with almost a straight line of performance in equity markets,” Gujral says.

Creating the minimum variance index range depends on an examination of correlations and co-variances between each pair of stocks, in order to estimate how they are expected to behave relative to each other.

“The min var approach is rooted in Markowitz investment theory, and looks at the correlations and co-variances between each pair of stocks to put together a portfolio that has a minimised expected variance.

“You take the overall portfolio which is the benchmark and add a constraint that the min var version should have 30 per cent of the constituents plus other optimisation approach limits.”

Unique to STOXX is a further filter which involves looking at the factors’ exposures of the min var portfolio and setting a threshold for those to remain within a certain range of the benchmark.

This means that the min var version will likely have similar attributes to the benchmark as well as achieving the objective of having minimum variance.

The min var approach is popular with a broad cross section of clients from traditional ETF product users who use it as an alternative to typical beta products, to institutions who perhaps see it as complementary to standard market cap weighted exposures.

“We think it is very useful in structured products where in order to create capital protected products, the min var index offers a cheaper solution than otherwise would be the case,” Gujral says.

He argues that min var investing is not smart beta in its truest sense. “We have positioned the min var not as a form of smart beta alternative that are typically unsuitable for standalone allocations but used mostly as building blocks within a broader portfolio. Min var portfolios conversely, provide investors with a complete portfolio management strategy allocating optimally to reduce risk.”

“It’s quite easy to see it being used to represent US exposure in place of a typical US ETF which captures the market cap weighted index,” he says. 
The STOXX Global 1800 min var index (USD Gross Return) between end 2009 and 2018 went up nearly 236 per cent cumulatively with an annualised volatility of 8.7 per cent, whereas the benchmark went up 217 per cent with a 13.3 per cent volatility. 

“Over a wider time frame you get this kind of out performance with a lower volatility,” Gujral says.

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