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Blog Posts — November 12, 2018

Minimum Variance’s Prowess in Risk Protection

October’s market move is the type of event that can determine a portfolio performance for the entire year. The sharp pullback in stocks has underscored the benefits of a low-volatility strategy: holding the less risky parts of the market has often been worth the price of missing out on the beta rallies.

Let us consider the performance of the STOXX® Global 1800 Index, a benchmark covering 25 developed markets. The index rose 5.1% in 2018 through September, before slumping 7.4% last month. On the other hand, the STOXX® Global 1800 Index Minimum Variance Index (Global 1800 MinVar), an optimized low-volatility strategy, climbed 3.7% between January and September and fell 4.5% in October. 

Quick math shows that the MinVar index is now outperforming its market cap-weighted benchmark this year, after an extremely volatile month that came to disrupt tranquil spring and summer trading. One month is all it took for the minimum variance strategy to undo the 2018 underperformance carried since April. 

The STOXX Minimum Variance indices track stocks that have exhibited the lowest individual levels of historical volatility. However, the strategy is optimized to account for sector and country biases and intra-stock correlation risk as defined by factors such as leverage and momentum. This avoids the concentration risk that is inherent in simple low-volatility strategies.

A strong run in last ten years

While there is nothing unusual about a low-volatility strategy outperforming, its rate of success is noteworthy. Even amidst one of history’s strongest and longest bull markets, the Global 1800 MinVar index has outperformed the market cap-weighted portfolio in five of the last 10 years. 

Moreover, the Global 1800 MinVar climbed 181% between Jan. 1, 2009 and Oct. 31, 2018.That compares with a 167% advance for the Global 1800 Index. One wonders how much more minimum variance would have outperformed had we instead endured more troubled markets. If we extend the above analysis to the start of 2007 to include the global financial crisis, the Global 1800 MinVar climbed 120% while the Global 1800 Index advanced 73%.

The comparison uses a constrained minimum variance index, or one that has a similar exposure to a market-cap index but with lower risk. STOXX also provides unconstrained versions of minimum variance indices, which have more freedom to fulfill the minimum variance mandate within the same universe of stocks. The unconstrained version of the Global 1800 MinVar index has also outperformed in five of the past 10 years. Its total return has lagged behind that of the benchmark Global 1800 Index since 2009 but has been ahead since 2007. 

A minimum variance approach is principally aimed at investors seeking risk protection. Its insurance potential is further reinforced as low-volatility stocks are cheaper to hedge through derivatives than are more volatile shares.

Yet minimum variance has also paid off in times of rising markets. One explanation is that market cap-weighted indices take on systematic, or undiversifiable, risk that a minimum variance strategy does not. The second reason is the so-called low-volatility anomaly, or the evidence that low-risk stocks outperform in the long run, a phenomenon that seemingly challenges traditional portfolio theory. 

Because of the effect of compound returns, stocks with smaller-than-average declines during a downtrend can recover more quickly. This year may yet again prove the prowess and advantages of capital protection, where the winning portfolios are those that lose the least. 

Total returns in dollars after taxes.