Skip to main content

You are here

Blog Listing Page

The right index for managing volatility?

By: Tom Goodwin, PhD, Senior Director Research

World events since the summer have been unsettling at best. From the Paris terrorist attacks to the ongoing refugee crisis in Europe, it’s been tough to find a headline that gives us any reassurance that we’re entering a time of global stability. Economic factors such as China’s economic slowdown and uncertainty over whether the US Fed will raise interest rates have already led to some market volatility and many expect this trend to continue. Investors facing the prospect of still more market uncertainty to come may want to look at a couple of different kinds of indexes - “low volatility” and “minimum variance” - which are designed to help investors make their decisions on managing volatility  in different ways. It’s worth clarifying the distinctions between these indexes because their aims and outcomes are distinctly different.

Today market participants understand that many sources of risk and return can be sharply focused into an index and used to measure a unique return pattern over a market cycle. But with the proliferation of these “smart beta” indexes there is potential for confusion. This is especially true when two indexes appear to have the same goal at first glance. Such is the case with low volatility and minimum variance indexes. 

Think of a bottom-up stock picker’s approach to portfolio construction. He assesses each stock individually based on a desired set of characteristics. He then overweights those stocks that score high on that set of characteristics and underweights or completely excludes those stocks that score low. That is the essence of a low volatility index, even though there is no actual stock picker, as an index is completely rules-based. The sole characteristic the index rules target is the return volatility (standard deviation) of each stock. Stocks with low volatility are emphasized while those with higher volatility are de-emphasized or not included at all.

By selecting stocks individually, the low volatility index rules maximize the capture of the low volatility “factor.” There is a body of research suggesting that this factor may generate excess returns relative to a cap-weighted index over a market cycle.1 Potential concerns are that in pursuing strong factor capture, unintended tilts to size, sector, country and illiquidity can occur. Also, a low volatility factor index can have an overall volatility that is only slightly smaller than its cap-weighted parent index.

Now think of a top-down “quant’s” approach to portfolio construction. She uses an optimizer to achieve a whole portfolio with desirable properties. The properties might include targets in risk, return, sector exposures, country exposures and more. She is not very concerned with what stocks the optimizer actually selects; she is only focused on whether the portfolio targets are achieved. This is essentially the approach of a rules-based minimum variance index.

The sole criterion of the index optimizer is the variance (squared volatility) of the whole index return. This has often resulted in the index having smaller drawdowns during market corrections. By taking a whole index approach, a minimum variance index takes into account the correlations between stocks.  But because correlations are considered, some of the lowest volatility individual stocks may not be included in the minimum variance index. Even so, there still is enough capture of the low volatility factor to support a return objective that is larger than the theoretical minimum variance portfolio, illustrated by the chart. Also, an optimizer can easily impose constraints that limit unintended tilts to maintain balanced exposures to the market. 

 

In choosing between these two types of indexes, it should be kept in mind that they both lower volatility, albeit to different degrees, and they both capture the factor premium, but also to varying degrees. The low volatility index has strong factor capture and it easily combines with other factor indexes constructed with a similar methodology, such as value, momentum and quality. The minimum variance index focuses on achieving the lowest overall volatility possible while maintaining a balanced exposure to the market. Clearly, having both of these indexes available increases market participants’ choice and flexibility.

Read more on the low volatility versus minimum variance indexes discussion.

[1] See the discussion and references in “Low Volatility or Minimum Variance: An ‘Eyes Wide Open’ Discussion,” FTSE Russell, 2015.

© 2015 London Stock Exchange Group companies.

London Stock Exchange Group companies includes FTSE International Limited (“FTSE”), Frank Russell Company (“Russell”), MTS Next Limited (“MTS”), and FTSE TMX Global Debt Capital Markets Inc (“FTSE TMX”). All rights reserved.

“FTSE®”, “Russell®”, “MTS®”, “FTSE TMX®” and “FTSE Russell” and other service marks and trademarks related to the FTSE or Russell indexes are trade marks of the London Stock Exchange Group companies and are used by FTSE, MTS, FTSE TMX and Russell under licence.

All information is provided for information purposes only. Every effort is made to ensure that all information given in this publication is accurate, but no responsibility or liability can be accepted by the London Stock Exchange Group companies nor its licensors for any errors or for any loss from use of this publication.

Neither the London Stock Exchange Group companies nor any of their licensors make any claim, prediction, warranty or representation whatsoever, expressly or impliedly, either as to the results to be obtained from the use of the FTSE Russell indexes or the fitness or suitability of the indexes for any particular purpose to which they might be put.

The London Stock Exchange Group companies do not provide investment advice and nothing in this communication should be taken as constituting financial or investment advice. The London Stock Exchange Group companies make no representation regarding the advisability of investing in any asset. A decision to invest in any such asset should not be made in reliance on any information herein. Indexes cannot be invested in directly. Inclusion of an asset in an index is not a recommendation to buy, sell or hold that asset. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional.

No part of this information may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without prior written permission of the London Stock Exchange Group companies. Distribution of the London Stock Exchange Group companies’ index values and the use of their indexes to create financial products require a licence with FTSE, FTSE TMX, MTS and/or Russell and/or its licensors.

The Industry Classification Benchmark (“ICB”) is owned by FTSE. FTSE does not accept any liability to any person for any loss or damage arising out of any error or omission in the ICB.

Past performance is no guarantee of future results. Charts and graphs are provided for illustrative purposes only. Index returns shown may not represent the results of the actual trading of investable assets. Certain returns shown may reflect back-tested performance. All performance presented prior to the index inception date is back-tested performance. Back-tested performance is not actual performance, but is hypothetical. The back-test calculations are based on the same methodology that was in effect when the index was officially launched. However, back- tested data may reflect the application of the index methodology with the benefit of hindsight, and the historic calculations of an index may change from month to month based on revisions to the underlying economic data used in the calculation of the index.

 

 

 

Blog Listing Page