Building Minimum Variance Portfolios with low risk, low drawdowns and strong returns

In the wake of the global financial crisis, minimum variance equity strategies quickly gained traction by capturing the attention of a risk-aware and risk-averse investment community. But minimum variance portfolios (MVPs) offer much more than just an efficient way to lower portfolio volatility. For a growing number of investors, MVPs are now seen as delivering the “best of all worlds”: low risk, low drawdowns and strong returns.

While the popularity of these strategies has been markedly more pronounced in recent years, it should be recognized that minimum variance has been in the market for decades. The theory from which the strategy derives its legitimacy is Harry Markowitz’s seminal work published in 1952, which was recognized by the Nobel Prize committee in 1990 . The practical importance of low volatility has been championed by R. Haugen and A. J. Heins since the mid-1970s, when it started to challenge the generally accepted paradigm of the Efficient Market Hypothesis of E. Fama .

Despite extensive academic research supporting the use of minimum variance, adoption of this strategy is still in the beginning stages. Important practical questions must be answered to provide clarity in the industry. With the focus on reduction of risk, it is natural to assume that there is a return trade off; however there is much academic research and increasing empirical evidence that a minimum variance portfolio provides strong historical total returns and Sharpe ratios. This evidence has seen the MVP become much more commonplace across the marketplace, with momentum growing among institutional investors, mutual funds and ETF sponsors.

STOXX has partnered with Axioma to create innovative minimum variance indices that start with a representative STOXX equity index and use Axioma’s multi-factor risk models to estimate a covariance matrix and the Axioma optimization tool to construct the optimal minimum variance index.

Since this paper provides an introduction to the STOXX Minimum Variance Indices, we aim to achieve three things:
i) an overview of minimum variance investing
ii) the methodology for the construction and maintenance of the STOXX Minimum Variance Indices, highlighting the unique approach for the index series
iii) how investors can make use of the minimum variance concept