The Comeback of Minimum Variance

The international financial markets are under the spell of the monetary turnaround of the most important central banks around the globe. Whereas in recent years the dominant theme of the FED, ECB, SNB and others was to support the economy and stabilize the financial markets, central banks are now returning to their core mandate of price stability. The tightening of the monetary reins not only triggered a price slide on the stock markets, but also caused historic losses on the bond markets. An extreme case is the 100-year Austrian government bond, which has lost more than half its value since the beginning of the year and is more than 70% off its peak (as of October 21, 2022).

This paradigm shift of the central banks has led to a turnaround in the financial markets: "QT" instead of "QE" - in other words, quantitative tightening instead of quantitative easing is the credo. The unprecedented rise in bond yields makes refinancing for companies and governments more expensive, thereby depressing the value of all assets due to the discounting effect. In particular so-called long-duration stocks, i.e., companies with earnings far in the future, have plummeted hard this year. Many technology stocks with supposedly promising business models turned out to be pipe dreams, similarly to the dotcom bubble bursting at the beginning of the millennium. Emblematic of this is the demise of ex-star manager Cathy Woods, whose ARK Innovation ETF stands at -63% year-to-date and has lost nearly 80% since its all-time high in February 2021. For investors, the certainty of central banks stepping in as buyers-of-last-resort is gone, as is confidence in a negative correlation between stocks and bonds. Tailwinds have become headwinds. "TINA" (There Is No Alternative [... to stocks]) became 10-year U.S. Treasury bonds with over 4% yield. The days when the tide lifted all boats and passive index funds were hard to beat seem to be a thing of the past.

In this extremely challenging environment, many investors are realizing again that risk management is an indispensable part of the investment process. While defensive investment strategies with a focus on low-volatility stocks had no chance in the liquidity-driven bull market of recent years, the tide has now turned since the beginning of the year. Some market commentators are talking therefore about a "comeback" of defensive strategies - such as our minimum variance approach.

Figure 1 shows the performance of the OLZ Equity World ex CH Optimized ESG (CHF hedged) and the MSCI World ex CH (85% CHF hedged)^[1]. Since the beginning of the year, the MSCI World ex CH index is down 19.4% (as of 21.10.2022). At the same time, the OLZ Equity World ex CH Optimized ESG fund has performed significantly better. Due to its minimum variance optimization, which minimizes the volatility of the overall portfolio, the fund was able to limit its downside and lost only 13.6%^[2]. The maximum loss suffered year-to-date also shows the benefits of risk optimization: instead of 23.1%, the maximum loss (i.e. the difference between the annual high and the annual low) amounts to only 15.6%, corresponding to a relative reduction of about one third. As expected, the defensive risk profile is strongly reflected in the volatility profile of the fund. This year's annualized volatility of OLZ Equity World ex CH Optimized ESG is a very low 7.1%, compared to the volatility of the MSCI World ex CH of 17.1%. Our targeted optimization of portfolio risk is therefore fully paying off in this turbulent market environment. Instead of relying on central bank support via economic stimulus and inflating valuations, active risk management in the equity portfolio is once again the order of the day.

It is also interesting to compare of our minimum variance equity fund with government bonds from the leading industrialized nations. Considering the FTSI World Government Bond Index with a seven- to ten-year maturity for comparison, we see in Figure 2 that the OLZ Equity World ex CH Optimized ESG has lost significantly less value since the beginning of the year (-13.4% vs. -18.1%). Moreover, our risk-optimized strategy even achieves lower volatility than the FTSI WGI bond index this year (7.1% vs. 7.3%).

The lower volatility of our equity funds allows our clients to use their risk budget more efficiently and to employ a higher equity allocation at the expense of government bonds. This has just paid off twice, as also the supportive effect of bonds is not present when equity and bond markets are positively correlated. Given the current economic and (monetary) political challenges, a risk-optimized sustainable equity portfolio offers an attractive risk-reward ratio and is therefore the strategy of choice for risk-conscious investors.