Consultants and advisors recommend minimum variance (MV) strategies because of their potential to lower absolute fund level risk while producing returns at least in line with a capitalization-weighted benchmark. Be that as it may, investors contemplating low volatility strategies are faced with a conundrum – although these strategies deliver less absolute risk than corresponding capitalization-weighted benchmarks, they can be a source of tracking error and represent an active bet for many investors.

Tracking error (ex-ante) represents the risk budget that investors who own underlying assets provide asset managers to beat a performance benchmark. Although investors may have strong convictions about MV strategies, high tracking error may give them pause since they require higher risk budgets. Some investors, for example, may have hard manager-level tracking error restrictions while others may be limited by the availability of tools or lack the required investment expertise to manage complex equity structures. Conversely, investors who are better equipped may prefer higher tracking error strategies that provide more concentrated investment exposure.

STOXX provides benchmark solutions for both sets of investors based on MV portfolios. Minimum variance provides a systematic way to build portfolios with the lowest possible ex-ante volatility without the need for subjective choices of stock selection parameters and weighting schemes, thus avoiding unintended bets that might ultimately degrade the effectiveness of the strategy. One index implements MV in its “purest” form, with a few rules to ensure liquidity and diversification. The other index is constrained to deliver lower tracking error relative to the capitalization-weighted parent index. Exposure restrictions on the constrained index limit the degree to which the index optimization algorithm is allowed to deviate from the market capitalization-weighted benchmark along industry and style dimensions.

The unconstrained index has better absolute performance and higher Sharpe ratios while the constrained index has lower tracking error and higher information ratios. Which index version should investors use? We explore this question in the remaining paragraphs.

Minimum Variance investing and the tracking-error conundrum