Less Risk, More Return?

January 26, 2012


However, Kang’s figures also show that low-volatility strategies can do particularly well in flat or down years for the overall equity market. Since the turn of the millennium, 2000, 2002, 2008 and 2011 have been years of particularly strong relative performance by such portfolios.

Investors should therefore be prepared for such periods of divergent returns between low-risk funds and capitalisation-weighted benchmarks, argues Kang. “Despite the potential of alternative beta strategies (including low volatility) to deliver better risk-adjusted performance than the market over the long term, investors may need to be prepared for periods of significant underperformance,” he writes in the Journal of Indexes Europe.

There is increasing evidence that investors are taking a long-term view and are prepared to devote money to index-tracking funds embedding such strategies.

Invesco PowerShares’ ETF tracking the S&P 500 low volatility index (NYSE Arca: SPLV) has raised over US$1 billion in assets in its first eight months. The firm recently added two more “low-vol” ETFs to track emerging and developed non-US equities, also based on indices from S&P.

In Europe, ETF issuer Ossiam, a subsidiary of Natixis Global Asset Management, is building its ETF range around non-standard, strategy-focused ETFs, and has now launched three funds that aim to minimise fund volatility, the latest being listed on the London Stock Exchange last week. Between them, Ossiam’s iStoxx Europe Minimum Variance (LSE: EUMV), US Minimum Variance (LSE: USMV) and FTSE 100 Minimum Variance (LSE: UKMV) ETFs have around €200 million under management, representing 80 percent of the firm’s total assets.

There’s a fundamental difference in construction between minimum variance and low-volatility indices, if not, apparently, in the end-results. A minimum variance portfolio is arrived at by a mathematical optimisation, using historical volatilities and correlations between stocks as the inputs. As pure optimisations can lead to imbalanced portfolios, constraints for individual stock and sector weightings and for a minimum number of holdings are often set as well.

As constraints for the FTSE 100 minimum variance ETF, for example, Ossiam and the index provider set a 4.5 percent maximum stock weighting and a 20 percent maximum sector weighting, with 50 shares as the minimum number of holdings.

Low-volatility portfolios are simpler in make-up, typically ranking stocks by their historical volatilities and then weighting them by the inverse of the volatility figure, with the least volatile stocks receiving the highest weightings.

According to Kang at Standard and Poor’s, who compared the returns of his own firm’s S&P 500 low-volatility index and MSCI’s optimised minimum volatility strategy over a 13-year period, both arrived at a similar reduction in volatility from a standard capitalisation-weighted approach, reducing this risk measure by about 20-30 percent. Although optimised, minimum variance approaches should in theory reduce risk by more than non-optimised strategies, the practical constraints applied to such funds may dampen the reduction, says Kang.

There’s an overlap between low-risk index approaches and other non-capitalisation-weighted strategy indices, for example value-weighted portfolios or the fundamental equity indices popularised by Research Affiliates, Alex Matturri, head of S&P’s index business, told IndexUniverse.eu. All these index methods often end up selecting similar stocks, usually those with higher dividend payouts, which produce a less volatile return stream to end investors, Matturri clarified. There’s increasing interest in replicating such market “factors” via systematic, index-based approaches, added Matturri, whose firm is building up its research efforts in this area.

With 2012 off to a flying start for equity markets—the Stoxx Europe 600 basic resources supersector index is already up 18 percent in January—many investors appear to be banking on the idea that this year will be one for momentum-chasing. However, a growing demand for strategy indices, including those promising low volatility, suggests that a longer-term shift in investors’ portfolio allocations is also taking place.


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