All about timing

Lynn Strongin-Dodds explains how market conditions may once again be right for minimum variance strategies to increase in popularity for investors

Minimum variance strate­gies are not new concepts but they have been gaining traction as stock markets continue to whipsaw on every shred of news. The promise of downside protection and robust risk adjusted returns are proving attractive but institutional investors are still proceeding with caution before taking the plunge.

Research from J.P. Morgan shows that European pension plans are ahead of the global pack, holding about 5 per cent to 8 per cent of their assets in minimum variance portfolios. “They are not yet main­stream and the majority still allocate to traditional benchmarks,” says STOXX global head of product development Konrad Sippel. “Also, minimum variance strategies today are sophisticated models that have been developed over many years, and which do address many of the issues that investors face in the financial crisis. As a result they require much more due diligence and this makes it a slower process. I expect the segment to grow as investors become more familiar and better understand what they entail.”

These strategies can trace their roots back to the modern portfolio theory of Nobel Laureate Harry Markowitz in the 1950s. They have enjoyed bouts of popularity but are usually relegated to the backburner once markets start to skyrocket. This is mainly because a minimum variance benchmark typically comprises stocks that are considered to be at the boring end of the investment spectrum. They do not fire the imagination in the same way as the high octane equities that capture the headlines and have the promise of double digit returns. Fund managers also had an additional incentive as their compensation often depended on their ability to deliver strong performances which are found in companies with the greater risks.

Not surprisingly perhaps, attitudes have changed and investors have been forced to re-evaluate their equity game plans. The financial crisis, ongoing eurozone saga and prolonged economic downturn may have been the spur but a closer look reveals that the performance of stock markets has been disappointing over the past decade. In fact, industry reports show that real returns from UK stocks during the 10 years to 2011 were a meagre 1.2 per cent per year while in the US, the market also languished, returning less than 2 per cent.

“In the late 1990s and 2009 equities jumped significantly but over the past decade market cap weighted benchmarks have twice fallen by more than 50 per cent - in the wake of the tech bubble and the collapse of Lehman,” says Unigestion managing director, head of equities Alexei Jourovski. “The last five to six years have been particularly disappointing because of the large drawdowns and this has made it difficult for pension funds to match their assets with their liabilities.”

BNP Paribas global head of institutional product engineering Bertrand Delarue adds: “The products have been out there for a while but there is definitely a big buzz in the market about low volatility and minimum variance strategies. One of the main reasons is that investors are questioning the claim of the traditional market cap indices to be the most efficient way to invest in equities. This has led them to look at different ways of building an equity portfolio.”

Few expect these low volatility portfolios to replace the stalwart market cap weighted benchmarks but many see them increasingly become a firm fixture. “Minimum variance strategies can be traced back several years but they were mostly in the confines of active equity managers,” says FTSE managing director, relationship management, EMEA Carl Beckley, adding: “The difference today is that we are seeing more money being managed in minimum variance passive equity strategies. This is because investors, alongside with traditional benchmark indices, are focusing on achieving equity beta but with lower volatility.”

According to Mercer global CIO, mainstream assets Russell Clarke, there are four main components of a global equity portfolio - traditional large cap equities in developed markets, emerging markets, global small caps and low volatility stocks. Within that there are three categories including minimum variance, quality and variable beta strategies. “They are all very different approaches with for example, quality being more fundamentally based and minimum variance being more quant oriented. They are though complementary and when combined offer investors a good diversification,” he adds.

The main benefits of these strategies, according to Robeco conservative equities senior port­folio manager Pim van Vliet “is that they offer downside protection in bear markets and over the long run they will offer better risk adjusted returns. Studies have shown that their performance is up to 1 per cent better than market cap weighted benchmarks with roughly a third of the risk. This is mainly down to what is called the low volatility anomaly.”

This is contrary to the long held view embedded in traditional finance theory - the Capital Asset Pricing Model - which suggests that to extract greater returns from an invest­ment, investors need to take on additional risk. Over shorter periods this is true and minimum variance will dramatically lag a euphoric market. For example, in the year ended March 2010 equity markets enjoyed a bull run with the MSCI World index up by 52 per cent while US-based minimum variance managers fell behind their bench­marks by around 15 to 25 per cent.

Empirical evidence from a growing crop of academic and industry studies though suggest they will manage to keep pace with the market-cap index if the rise is more gradual and they will deliver superior returns with lower risk over a full market cycle. Recent research pub­lished by Robert Haugen, president of Haugen Custom Financial Systems, a US based research firm and Nardin Baker, chief strategist at Global Alpha, Guggenheim Partners Asset Management found that low volatility stocks consistently beat the market in all of the 21 developed countries they studied between 1990 and 2011.

Adopting an even longer time horizon showed that the least-volatile quintile of the 1,000 biggest stocks in the US returned 10.2 per cent annually from 1968 to 2010, while the most-volatile quintile gained only 6.6 per cent, according to US based Acadian Asset Management director of managed volatility strategies Brendan Bradley, who earlier this year published a study on the returns of low-volatility stocks with Harvard University Malcolm Baker and New York University Jeffrey Wurgler in the Financial Analysts Journal. The US stock market overall returned 9.6 per cent during the same period.

The one drawback that is unavoid-able is tracking error, according to AQR Capital managing director Christopher Palazzolo. “This is because the whole point of a low volatility strategy is to tilt away from a market cap weighted benchmark. If you lower it then you introduce some form of cap weighting and therefore reduce the benefit of the strategy and the Sharpe ratio will go down.”

The lesson then is that investors need to be patient and not be lured away once markets start to climb. Allocations will also of course depend on a fund’s particular requirements and risk appetite. Index providers though are seeing increased demand and have responded by launching and broadening their existing offer­ing. For example, FTSE recently expanded its minimum variance range by adding eight new bench­marks providing a greater geo­graphical reach.

Meanwhile in May, STOXX launched its minimum variance indices based on a factor model developed jointly with Axioma, a firm specialising in risk management tools. They come in two versions - constrained and unconstrained.

In the latter, the exposure to the Axioma factors is limited to one quarter of the standard deviation of the underlying index’s exposure, with the exception of size and risk, which are not used as constraints. Full investability, component weight capping, diversification, turnover, and capping of currencies and industry exposure are also on the list. They are rebalanced quarterly in line with the respective underlying index. The unconstrained variations are not subject to any factor, currency or industry exposure requirements, and are rebalanced on a monthly basis.

Written by Lynn Strongin-Dodds, a freelance journalist

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