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STOXX Minimum Variance – Winning More by Losing Less

Oct. 29, 2015

Oct. 29, 2015

Global equity markets have enjoyed a sustained bull run since 2009. But the steep fall in Chinese stock markets and its reverberations worldwide show just how fragile investors’ confidence can be. In an uncertain world, the challenge for providers of investment products is to harness the attractive returns that equities offer while avoiding the destructive effects of the market’s inherent volatility.

The STOXX Minimum Variance strategy meets this challenge by building equity indices that are far less volatile than their traditional market-capitalization-weighted equivalents. Drawing on Nobel prize-winner Harry Markowitz’s Model Portfolio Theory and Axioma’s fundamental factor model, STOXX has created a series of indices that offer full exposure to the equity markets with the lowest possible level of volatility.  

Not all low-risk approaches are equal

Low-volatility or minimum-variance indices can be created in different ways. Some simplistic approaches merely take the stocks that have exhibited the lowest individual levels of historical volatility, giving those stocks the highest weightings in the index.  That may sound like a reasonable approach – but it fails to take into account correlation risk which poses a risk to portfolios.. The 2008 global financial crisis provides a clear example: financial stocks had previously been regarded as low risk – but sold off savagely en masse when the crisis struck. A portfolio with a heavy weighting in the sector would have been massively overexposed to the correlation risk generated by the event.

STOXX Minimum Variance – a step ahead

Genuine minimum-variance strategies offer a more sophisticated approach that does take correlation risk into account. The STOXX Minimum Variance index uses Axioma’s modeling use factors such as leverage, liquidity and momentum. But there are very few such strategies on the market.

Crucially, the STOXX Minimum Variance indices are the only minimum-variance products to offer a fully unbiased factor-based approach that covers the broad range of global indices. Moreover, the STOXX indices are the only ones on the market to benefit from daily updating of their factor model. The closest competitor updates on a monthly basis – meaning that its model can often be up to a month out of date.

Constrained and unconstrained

Unlike their competitors, the STOXX Minimum Variance products are available in both unconstrained and constrained versions:

- The unconstrained indices offer an unbiased minimization of risk to provide the lowest possible risk and have historically provided the highest long-term returns

- The constrained indices have a smaller tracking error relative to conventional indices, but still offer much reduced risk and have also historically generated returns superior to the benchmark.

The regular rebalancing of both indices ensures that the indices continually evolve to avoid the more volatile areas of the equity market. To ensure compliance with UCITS directives, the STOXX Minimum Variance indices adopt a “4.5%/8%/35%” model. This means that no single holding is greater than 8% of the portfolio, and the sum of all those holdings equal to or greater than 4.5% of the portfolio amounts to no more than 35% of the total.

Consistent outperformance

Since inception, the STOXX Minimum Variance indices have delivered consistent outperformance of conventional equity indices. Extensive backtesting indicates that this outperformance is sustainable over the long terms. Since 2002, the average annual return of the STOXX Minimum Variance indices is 10.16%, compared with 8.50% for conventional benchmarks. This represents annualized outperformance of 1.66%. Compounded over a substantial time period, that degree of outperformance holds obvious attractions for any investment portfolio.

An important principle underlying the performance of the STOXX Minimum Variance strategy is “winning more by losing less”. When markets are weak, the Minimum Variance strategy tends to outperform significantly – and this downside protection preserves capital, allowing the portfolio to benefit more fully from the rising markets that follow.

That’s not to say that STOXX Minimum Variance outperforms only in weak markets. In fact, backtesting shows that the Minimum Variance model outperforms in most rising markets too. The combination of outperforming in most “up” years and in almost all “down” years creates a particularly potent return profile. 

In an uncertain world, therefore, the STOXX Minimum Variance indices offer a welcomed source of stability in returns – allowing investors to harness the return potential of the stock market without the associated volatility.

 

 

Please share your feedback, comments or questions by sending an email to our editors at pulse@stoxx.com.

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