At a time when Solvency II is increasingly causing European insurers to question the benefits of retaining exposure to equity portfolios, investors less constrained by regulation can still think about those investment strategies best suited to their needs and to the changing economic and financial climate. Of the major trends observed on equity markets since the financial crisis struck, the increase in volatility resulted in risk management climbing to the top of the agenda. This finding is particularly emphasised in the most recent survey carried out by Baring Asset Management on British pension funds. In response to this development, minimum variance (or low volatility) funds have been developing over the last few years. They promise a significant reduction in volatility compared to that displayed by broad benchmark indices.

The risk reduction promises made by the funds evaluated by bfinance when calling for tenders to select fund managers vary between 20% and 40% taken over a three-year time span, compared to the volatility of their benchmark index (MSCI World in this case). Although such objectives may seem ambitious, recent experience tends to lend them credibility. Of the funds evaluated, over 80% managed to reduce volatility by over 25% on average, irrespective of market configuration. The majority of funds kept their promises when volatility started to rise in summer 2007, at the time that the first harbingers of the financial crisis appeared. These investing techniques then successfully weathered the peak of volatility observed after the collapse of Lehman Brothers, and then the period of returning to normal that followed it. Between mid-2009 and mid-2011, the performance in terms of risk reduction displayed by many funds exceeded 35%, or even 50% for the best performing products.

A developing product range

However, the evaluation covers a relatively small sample of funds, which were pre-selected from almost 400 fund managers on the basis of investor needs. On top of a significant reduction in volatility, investors were looking for a quantitative investment approach applied to world equity markets, capable of outperforming their benchmark index, in which over €100 million was to be invested. Faced with these constraints, it would appear that one manager out of every three does not use a minimum variance strategy, that almost one out of every four does not offer the required investment style and that almost one out of every seven does not have a fund with sufficient assets under management to absorb significant investment.
Moreover, since the minimum variance approach only really started to become widespread over the last few years, the track record is seldom more than five years, except in a handful of funds. This limited track record gives rise to questions as to the behaviour of the investment approaches in less volatile phases of the market, such as those observed between the bursting of the internet bubble and the beginning of the 2007 financial crisis. Several investment managers decided not to submit an offer because of the lack of any significant track record.

Outlook for returns

While addressing risk is the central parameter in minimum variance investing, this approach is not merely applicable to investors focussing solely on this parameter. Behind the scenes, most funds evaluated by bfinance are trying to generate a return in excess of that of their benchmark index. Outperformance targets can reach as much as 5% per year over a three-year horizon. Evaluation of past performance shows that minimum variance funds outperform their benchmark index when markets are falling. Over the periods November 2007-March 2008, April 2008-February 2009 and May 2011-August 2011, which correspond to significant falls in equity markets, the median of the funds outperformed their benchmark index by 4.34%, 14.36% and 7.60% respectively. In months during which the markets fell, the median of the funds kept losses down to almost half while the best funds managed to beat their benchmark index in almost all the months in question. Conversely, at times when the market was rising steeply, as observed in March 2009-April 2010 and May 2010-April 2011, the median of the funds underperformed by 26.30 % (on an MSCI World USD performance of 63.88% for the period) and 0.51% respectively. During phases of rising markets, the median of the funds approached two thirds of the performance of their benchmark index, with the best funds even managing to beat their benchmark index one time out of every three.

To achieve their targets, these very quantitative investment approaches can rely solely on risk projections (a somewhat passive approach), or could combine them with expectations of alpha and/or take discretionary actions unconnected with the quantitative model. In the case of the funds we evaluated, some managers allowed themselves the option of investing in securities not forming part of the index (MSCI World), or even ones in a completely different investment universe. Some funds also stood out by retaining significant exposure to small- and mid-caps, by investing part of their portfolio in emerging countries or even subjecting their investments to an ESG filter.

Minimum variance investing is often criticised for favouring a tight concentration of investments. The funds evaluated imposed maximum exposure restrictions to any single security of between 1% and 3% and, for around half of the funds, exposure limits to any single sector that varied between 10% and 30%. At the time of the evaluation, the number of portfolio holdings stood at between 55 for a fund with a target of between 50 and 80 holdings, and 288 for a fund with a target of between 200 and 350 holdings.

Furthermore, a snapshot of the makeup of the funds at the end of August showed a sector bias skewed towards holdings associated with consumer staples, while most of them were underweight in financial and industrial stocks.

Management expenses

Analysis of fixed management fees brings to light great disparities between funds: proposals ranged from single to quadruple, yet again emphasising how young this approach is. Alongside fee structures based solely on fixed commission, most fund managers were able to offer formulae combining fixed and variable components. In the great majority of cases, the variable component was 20% of outperformance, with a reduction in fixed commission.

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