During the ongoing financial crisis, it has become clear that investing in equities with an eye toward the long-term return premium can lead to substantial periods of drawdown. It makes sense, therefore, to see a renewed interest in products and strategies aimed at trying to capture this premium at a potentially lower risk level. This strategy is not something new; the low volatility phenomenon was described in the early 1990s by Haugen and Baker. More recently we have seen a related but slightly different approach, namely, minimum variance, as described by Clarke, de Silva and Thorley (2006). Not only have managers deployed these strategies, but such is their popularity that we have recently seen these techniques being deployed by benchmark providers and provided as commercially available ETFs.
Although the two concepts are related and share a common goal (a better risk return profile), there are slight nuances in either approach. Low volatility strategies describe the outperformance of stocks with a lower price fluctuation. Minimum variance takes into account correlations between assets and looks at the volatility of the portfolio rather than the individual securities. Rather than selecting stocks with low and potentially shorting securities with a high (idiosyncratic) volatility, minimum variance focuses on constructing generally long-only portfolios in a way that minimizes the absolute risk.
In our latest white paper, we consider minimum variance investing, not as an advocate, but to examine some of the characteristics of these strategies and how they can potentially be blended with traditional passive market cap weighted investing to improve returns.