Minimising Index Risk By MVP

As the UK share market shows possible signs of weakness early in 2024, we look at ways of reducing equity risk.

In an earlier blog, we explored the FTSE 100 Target Volatility index, which adjusts its exposure to equities and cash to target a specific level of index volatility.

In this blog we look at another, quite different defensive equity strategy, the FTSE 100 Minimum Variance index.

What is a minimum variance index?

The objective of a minimum variance index is to create a portfolio of stocks with the lowest overall volatility, subject to defined constraints.

The aggregate volatility of a portfolio depends on two things:

• The volatility of the individual stocks within the portfolio
• And their correlations with other stocks.

A minimum variance portfolio (MVP) doesn’t necessarily select the stocks with the lowest past volatility, considered individually. This is because uneven correlations between stocks provide scope to reduce the aggregate portfolio volatility through diversification.

[If this sounds confusing, imagine two stocks that move in perfect opposition to each other—if one is up on one day by X%, the other is down by the same amount, and vice versa. A 50/50 portfolio of both these stocks would not move, even if the two stocks were quite volatile when considered in isolation.]

How we build it

We build the FTSE 100 Minimum Variance index by building a matrix including data on stocks’ historical volatility and their pairwise correlations (how each stock in the index has moved in relation to each other stock).

Using this so-called covariance matrix, we run a computer programme called an optimisation. The output of the optimisation is the mix of stocks (and their respective weights) that minimised the past volatility of the index.

FTSE Russell’s approach to building minimum variance indexes is to take a “light touch” approach to the index methodology: we limit the number of constraints and ensure diversified outcomes.

For example, in the FTSE 100 minimum variance index we specify that no individual stock can represent more 4.5 percent of the index by weight and that individual industries cannot represent more than 20 percent at the regular index review. The index has a minimum diversification target as well^[1].

In aggregate, these constraints also have the effect of limiting index turnover at the periodic index reviews. As stock volatilities and correlations change over time, the minimum variance index needs to be rebalanced regularly by means of a new optimisation. The mix of stocks that minimised index risk in one period won’t necessarily be the same as the mix minimising risk in the next period.

Does it work?

The most important feature of a minimum variance index is that it is all about risk reduction. And, as we can see from the charts, the FTSE 100 minimum variance index reduced the risk of the starting index (the FTSE 100) fairly consistently over the ten-year period to end-2023—and, in particular, during the volatile period that followed the outbreak of the coronavirus pandemic in early 2020.

During that volatility spike, the FTSE 100 minimum variance index cut the risk of the FTSE 100 by up to six percent.

Annualised Volatility (60-day Trailing)

Volatility Reduction Vs FTSE 100 (60-day Trailing)

What about returns?

Minimum variance is not a return-focused strategy: in other words, the index is designed to minimise risk. Its return is a secondary outcome of this risk-reducing objective.

Nevertheless, in seven of the eleven years between 2013-2023 (inclusive) the minimum variance version of the FTSE 100 produced a higher return than the FTSE 100, and minimum variance outperformed each time the FTSE 100 had a down year (in 2015, 2018 and 2020).

Annual Returns

Taking a snapshot of the two indices as at March 2020 (see below), the FTSE 100 minimum variance index had notably lower exposure than the FTSE 100 to the Oil and Gas industry, and higher exposure than the FTSE 100 to the Consumer Services industry.

FTSE 100 Min Var Net Quarterly Returns VS FTSE 100

Click to enlarge

Footnote: Industry exposures as at March 2020

This may explain the relative strong performance of the minimum variance approach during the first part of the pandemic in 2020. In that year the Oil and Gas industry gave a -40.6% return, versus a -11.5% return for the FTSE 100 as a whole.

A Useful Addition

What does all this mean? Minimum variance’s principal goal is to reduce equity risk, and judging by these results it does so successfully.

And, returning to the question at the beginning of the blog—how to keep some exposure to UK equities while reducing volatility and without necessarily compromising returns—a minimum variance strategy is a useful addition to investors’ toolkit.

1. For details, see FTSE 100 Minimum Variance Index: Ground Rules (lseg.com)

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