In the wake of the financial crisis, minimum-variance strategies quickly gained traction by capturing the attention of a risk-averse and risk-aware investment community. Minimum-variance strategies help investors defend themselves against losses during market declines and, unsurprisingly, could have proved helpful during the financial crisis.
This year the usefulness of minimum-variance strategies was put to the test when the Brexit vote sent equities across the world into a tailspin only to see them rebound strongly and then retreat again. U.S. and European equities plunged on June 24, as Britons chose to relinquish their European Union membership, surprising pollsters and analysts in the U.K. and around the world. On June 28, following a second day of declines, investors may have reconsidered the impact of the vote on global growth, as indices climbed through July 1. Concerns re-emerged in the following days, as a political crisis in the U.K. expanded, sending stocks lower for two straight sessions. By July 8, benchmark European indices showed significant losses, and U.S. indices rallied back to where they were before the vote.
Fortunately, for investors who were holding minimum-variance investments in their portfolios, these strategies did what they are designed to do: reduce drawdowns. This is shown in the table below, which compares performance of the STOXX USA 900 Minimum Variance Unconstrained index with the S&P 500 index.
Source: STOXX and Bloomberg
Minimum-variance strategies typically have smaller drawdowns and can more quickly recover losses. In fact, a large share of returns from minimum-variance strategies result from the compounding effect of smaller drawdowns. As has been said in the past, minimum variance "wins by losing less." A longer-term comparison between a minimum-variance index and a broader market index helps to illustrate the benefit of compounding.
The table below shows the 14-year performance of the STOXX USA 900 Minimum Variance Unconstrained index and the S&P 500 index. As you can see, the minimum-variance index provided a higher annualized return than the S&P 500 index.
Source: STOXX and Bloomberg
The above table illustrates that minimum-variance strategies can offer much more than just tactical defense for periods of market instability. In fact, there is a breadth of research and increasing empirical evidence attesting to the strong historical total returns and Sharpe ratios of minimum-variance strategies. Correspondingly, more and more investors are using minimum-variance strategies to gain access to low risk, low drawdowns and strong returns.
If an investor is considering a minimum-variance strategy, it is important that he or she understand how they are constructed, because each option may meet a different investment goal. Two examples of minimum-variance index choices available to investors today are constrained and unconstrained versions. The constrained version is designed to lower volatility, while still tracking the performance of the cap-weighted index, within a certain range. This is helpful for investors who are benchmark sensitive. The unconstrained version is free from any constraints to an underlying index. Its only constraints are regulatory ones.
STOXX recently announced the licensing of its USA 900 Minimum Variance Unconstrained Index to Recon Capital Partners as the underlying index for an exchange-traded fund. This ETF will offer U.S. investors access to an innovative minimum-variance investment strategy that reduces portfolio risk and potentially improves long-term returns.Minimum variance strategies have become widely popular over the past few years, as risk awareness and risk aversion following the financial crisis have driven investors toward less-risky investments. With minimum-variance strategies, investors have found a way to not only lower risk but also to maintain and enhance returns over the long term.