There are times when markets are hit by bouts of volatility. Panic can set in when share prices move wildly. There’s even an index that shows a 30-day expectation of the phenomenon, the Chicago Board Options Exchange Volatility Index known as the ‘VIX’.

There are plenty of ways to try and mitigate volatility; one popular method is moving your money into traditional safe havens like gold. Another technique is minimum variance, originally an invention and tool of institutional investors but now available through smart beta exchange-traded funds (ETF).

Low volatility ETFs have become increasingly popular, helping investors gain exposure to a portfolio of low volatility stocks and avoid the more extreme swings in the market.

Minimum Variance ETFs are subtly different in that they aim to achieve a portfolio with the lowest possible volatility.

Why invest in a minimum variance strategy now?

There are major European elections happening this year in France, Germany and the UK.  Any surprise news associated with the elections could rock stock markets around the world.

Being in a minimum variance ETF could limit gains if the market shrugs off the risks associated with elections and stocks continue to climb. But it could also help reduce the impact of any downside risk if the market tumbles.

Understanding how it works

Minimum variance seeks to exploit a quirk in market efficiency. Stocks in certain configurations produce long-term returns at least equal but hopefully better than the market.

Bruno Monnier, a fund manager at French ETF boutique Ossiam, says if you target stocks using just low volatility as a measure, you’ll ‘mechanically’ lower the risk. There are problems with doing this though. If you choose a concentrated portfolio of a few low volatility stocks, a single stock could undermine your performance.

Counterintuitively Monnier says one of the benefits of minimum variance as a strategy is the ability to include highly volatile stocks within the ETF wrapper. Ossiam FTSE 100 Minimum Variance UCITS ETF (UKMV) contains some so-called high beta stocks like gold miner Randgold Resources (RRS).

In summary, this is thanks to the low levels of correlation some high beta shares have with the rest of the market. This allows them to contribute to a reduction in the volatility of an index as a whole.

Ossiam has a range of minimum variance products covering continental Europe, the US, Japan and emerging markets.

Protecting diversification

One of the key advantages of using this strategy according to Lyxor’s head of ETF strategy for Northern Europe Adam Laird is diversification.

He says his firm uses FTSE Minimum Variance indices because, unlike traditional minimum volatility ETFs, they are built to protect diversification. ‘They generally hold around two in every three companies in the underlying index – meaning your basket is well spread,’ says Laird.

Lyxor has a global range of minimum variance ETFs, including the FTSE Europe Minimum Variance UCITS ETF (MVEX) and the FTSE Emerging Minimum Variance UCITS ETF (MVMX).

But for all the advantages of using minimum variance and other related low volatility strategies, some people think they might artificially inflate the valuations of certain stocks. This is a major concern of one of the godfathers of ‘smart beta’ Rob Arnott, head of Research Affliates, a major provider of smart beta indices.

Arnott says that investors have piled into low volatility funds not because of a genuine belief in the strategy but because the prices of these ETFs were rising. Arnott says this ‘performance chasing’ means low volatility and minimum variance strategies are trading at high valuations compared to historic norms.

Ossiam’s Monnier dismisses these concerns. ‘Minimum variance has grown but compared to the rest of the market it’s tiny so you will not lose your benefits,’ he says.

Lyxor’s Laird says it is possible that investors might herd into the strategy but doesn’t believe performance chasing is the reason.

Not a sure thing

An important point to remember about minimum variance is that it is still an equity strategy and therefore not without risk. Also, if there’s a bull market in equities, when investors are in a ‘risk-on’ mode, these types of strategies are not necessarily best suited.

But minimum variance is not about market timing, it’s a strategy to keep in your portfolio for the long term. You won’t catch all the upside of a bull market but conversely you shouldn’t lose your shirt when markets turn either.

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