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Minimum variance indexing—an antidote for the seasick

By: Tom Goodwin, Senior Research Director

In a world where significant market volatility and drawdowns have become common-place, market participants are eager to find a means of maintaining equity market exposure while attempting to save themselves from the motion sickness associated with wild market swings. According to the 2016 FTSE Russell smart beta survey, risk reduction is the second highest investment objective when evaluating smart beta strategies.[1] And where there is index demand, a variety of options will inevitably be created to satisfy it—among them is minimum variance indexing.

The minimum variance approach is one of several indexing options for risk/volatility reduction and each have their pros and cons. There is the basic risk weighted approach that simply weights stocks within an index in inverse proportion to their volatility. This approach, while simple to understand, does not control for index concentration risk in countries, industries or stocks. Another option is the low volatility factor approach which is designed to target the low volatility factor by selecting exclusively low volatility stocks. This method is designed to capture the low volatility risk premium and is not primarily intended to reduce index risk.

The minimum variance approach to indexing is designed specifically to reduce volatility/risk at the index level. Using an optimizer with historical data, the smallest index variance is achieved by taking into account both the volatilities of individual stocks and the correlations between them. Constraints on concentration and liquidity are applied by the optimizer to create a diversified and liquid index with the lowest possible volatility.

Below, we compare the three index risk reduction techniques described above to a market cap weighted benchmark—here, the FTSE USA Index. As we can see, the FTSE USA Minimum Variance Index has provided the greatest level of volatility reduction of the three options—the Risk Weighted Index and Low Volatility Factor Indexes used here are hypothetical and have been created for the sake of comparison for this analysis.

The chart below illustrates how the performance of our three index risk reduction techniques has fared since 2000. While the hypothetical Low Volatility Factor Index has remained quite close to our benchmark, the hypothetical Risk Weighted and FTSE USA Minimum Variance indexes have recorded higher index levels than the market-cap weighted FTSE USA Index. Since the 2008 financial crisis, the FTSE USA Minimum Variance Index has seen the highest performance of the three. If we break down the various implicit factor exposures accessed through each technique, we can get a better understanding of the drivers behind this performance.

In the chart below we illustrate the variation in the average, implicit factor exposures between our three risk-reduction indexing techniques and the market-cap weighted benchmark. It is clear that the size factor plays a significant role in the varying performance of both the FTSE USA Minimum Variance and Risk Weighted indexes compared to the benchmark.

Finally, valuations can be a significant concern with these differing indexing techniques, especially with the more complicated construction methodology of the FTSE USA Minimum Variance Index Series. Our research has revealed that the current valuation levels of the FTSE USA Minimum Variance Index are in line with the valuation levels of the cap-weighted FTSE USA Index.[2] 

As we enter this new year with plenty of new uncertainties, market participants may be interested in a more sobering means of assessing the equity market and may want to take a closer look at the index risk-reduction options that are available if they are searching for an index equivalence of Dramamine to a seasick sailor.

For more information on this topic, please see more detailed overviews of the FTSE Minimum Variance Index Series.

 

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[1] Source: 2016 Smart Beta Survey 46% of respondents cited risk reduction, 58% cited return enhancement.

[2] FTSE Russell. Data from September 2000 to August 2016. Past performance is no guarantee of future results. Returns shown may reflect hypothetical historical performance.

 

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