Over the past four decades, a long-only minimum-variance portfolio has outperformed the benchmark S&P 500 Index by 1.64% per year. The authors analyze the various attributes responsible for this outperformance and the resulting increase in the value exposure on the Sharpe ratio of the minimum-variance portfolio.
What’s Inside?
Factor analysis of minimum-variance portfolios reveals that style factors, such as volatility, size, and value, are responsible for the anomaly of earning a higher return while bearing lower risk. The popularity of the minimum-variance strategy has led to investors starting to pay a premium for lower-risk stocks, thus making it difficult to construct a minimum-variance portfolio at lower cost. But the authors show that this cost can be lowered by using a value-tilted minimum-variance strategy.
How Is This Article Useful to Practitioners?
In the capital asset pricing model theory, risk and return of a security are linear in relation to each other. But empirical research conducted by Black, Jensen, and Scholes (Studies in the Theory of Capital Markets 1972) found that in frictionless markets, low-beta stocks generate higher risk-adjusted returns than high-beta stocks. Since then, low-risk strategies have been very popular among investors, and the results of backtesting by the authors confirm that higher returns can be earned while bearing lower risk.
The authors find that during 1973–2012, minimum-variance portfolios generated higher annualized returns of 11.4% compared with the 9.8% return of the S&P 500 Index. During the same period, minimum-variance portfolios had a Sharpe ratio of 0.5 compared with 0.34 for the S&P 500.
Factor analysis shows that the size factor was one of the biggest and most consistent contributors, with an active return of 0.62% per year. A minimum-variance portfolio has a small-cap bias, and as investors start paying a premium for these stocks, costs to enter into a minimum-variance portfolio increase. But the authors show that this cost can be avoided by using a value-tilted minimum-variance strategy. The findings would be useful for every investor who wants to pursue a minimum-variance strategy by optimizing the value exposure.
How Did the Authors Conduct This Research?
To analyze the performance of a minimum-variance portfolio compared with the benchmark index S&P 500, the authors use the Barra USE3 factor model. The factor model incorporates both industry and style factors, such as size, volatility, value, and momentum. Within a category of value-type factors, the authors use such attributes as earnings yield, price-to-book ratio, and dividend yield. They choose the sample universe of S&P 500 stocks to create a minimum-variance portfolio because the stocks are more liquid. A minimum-variance portfolio is long only, rebalanced quarterly, and optimized to keep the portfolio’s standard deviation lower.
Abstractor’s Viewpoint
The article offers good insights for fund managers who want to maximize return without increasing any substantial risk.