Authors Ruben Falk Senior Product Manager 212-438-0648 rfalk@capitaliq.com Martin Vostry Senior Business Analyst 303-721-4270 mvostry@capitaliq.

com Arun Soni Senior Product Specialist +44 20 7176 1279 asoni@capitaliq.com Bala Balachander, PhD Senior Quantitative Analyst 617-530-8103 bbalachander@capitaliq.com

Constructing portfolios with the sole objective of minimizing risk would have been a successful strategy, by most measures, since the implosion of the technology bubble in 2000. In fact research demonstrating the outperformance of low risk stocks and equity portfolios dates back to the early 1970s. Of course, these findings run counter to Modern Portfolio Theory according to which a specific (lower) level of risk can be most efficiently targeted by adjusting (increasing) the cash holdings in a portfolio and that a fully invested portfolio should target the market portfolio. Using our US Equity Risk Model, this month we explore how minimum variance portfolio construction can be leveraged to increase portfolio returns. Summary of Findings: From April 1998 to October 2010, our Minimum Variance (MinVar) portfolio without sector or style constraints easily outperforms the S&P 500 and S&P 1500 with much lower risk Portfolio construction with a minimum variance objective naturally lends itself to a large cap. but not mega-cap. bias During this period, the minimum variance objective has the effect of over allocating to traditionally defensive sectors such as Consumer Staple and Utilities while under allocating to Financials and Technology Imposing sector constraints has the effect of lowering returns and increasing risk Style constraints, however, when combined with certain specific style tilts, enhance the performance of the MinVar portfolio As a side effect the style factor exposures that are generated from minimum variance portfolio construction provide useful input for factor switching strategies, at least in the case of Value and Price Momentum The results are quite robust for different style tilts which suggests that many existing strategies could use minimum variance as a performance enhancing overlay

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Constructing portfolios with the sole objective of minimizing risk would have been a successful strategy, by most measures, since the implosion of the technology bubble in 2000. In fact, research demonstrating the outperformance of low risk stocks and equity portfolios dates back to the early 1970s. Of course, these findings run counter to Modern Portfolio Theory according to which a specific (lower) level of risk can be most efficiently targeted by adjusting (increasing) the cash holdings in a portfolio and that a fully invested portfolio should target the market portfolio. Various explanations for why risk is mispriced have been offered; the most common one of which is that leverage restrictions incite some investors to chase volatility at the individual issue level. In this paper, we will not focus in great detail on why this anomaly exists but instead explore various methodologies for construction of minimum variance portfolios of US listed equities and analyze the features of these portfolios. Prior research has shown that low beta stocks earn more than their beta implies (Fama/McBeth 1973), and investors tend to overpay for volatility (Blitz/Vliet 2007, Ang 2006). Early empirical work from Haugen/Baker (1991) showed that the minimum variance (MinVar) portfolio outperformed the Wilshire 5000 at lower risk from 1972 to 1989. Many studies followed the original paper. For the US stock market, Chan/Karceski/Lakonishok (1999), Schwartz (2000) and Jagannathan/Ma (2003) and Clarke/Silva/Thorley (2006) found both higher returns and lower realized risks for the MinVar portfolio versus a capitalization weighted benchmark. Scherer (2010) shows that 79% of the variation of the MinVar portfolios excess return can be attributed to exposure to low market beta and low stock specific risk. Exposure to the Fama-French value and size factors are other characteristics noted. As a starting point we create a time series of MinVar portfolios using a set of basic parameters and constraints: Portfolio size $1.5BN (initial), long only Monthly rebalancing, Apr. 1998 to Oct. 2010 Objective: Minimum Variance at each rebalancing Risk Model: Capital IQ US Fundamental Medium Term Universe: S&P 1500 Max 100 Holdings (not always binding) Max trade size: 10% of ADV Trade costs: 25bps Max holding size: 3% of portfolio per name Threshold holding and trade size: $50k

Base Case: No Risk Factor Constraints We compare the performance of the MinVar portfolio against the S&P 1500 from which the portfolio is drawn and against the main constituent benchmarks of the S&P 1500, namely the S&P 500, 400 and 600. The MinVar portfolio gained 6.0% annualized from April 1998 to October 2010 with an annualized standard deviation of 10.6%. This compares favorably to the S&P 1500 and S&P 500, which gained 3.4% and 2.8% with a risk of 16.6% and 16.5%, respectively. The MinVar portfolio underperformed the smaller cap. benchmarks of S&P 400 and S&P 600 albeit still with significantly lower risk. As we shall see later, the market capitalization group allocation of the MinVar portfolio indicate that the S&P 500 and/or S&P 1500 are in fact the most relevant benchmarks. Figure 1 shows the comparative risk and return characteristics and their respective Return/Risk Ratios.

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Figure 1: Base Case MinVar vs. Benchmarks, April 1998 October 2010 Ann Return MinVar (Pre Tcosts) MinVar (Post Tcosts) S&P 500 S&P 400 S&P 600 S&P 1500 6.0% 5.1% 2.8% 8.7% 6.9% 3.4% Ann Risk 11.4% 11.4% 16.5% 19.3% 20.7% 16.6% Return/Risk Ratio 0.53 0.45 0.17 0.45 0.33 0.20

The time period evaluated covers the tail end of the technology run-up from April 1998 to the end of 1999 during which period the MinVar underperforms the main benchmarks (Figure 2). In fact, although not covered explicitly in this paper, the entire technology run-up from early 1996 was not a good period for minimum variance strategies. On the other hand, MinVar has outperformed the relevant large cap. benchmarks consistently in the wake of the technology bubble bursting and has had a particularly strong bounce since the most recent market trough in March 2009.

Figure 2: Cumulative Performance of Base Case MinVar vs. Benchmarks (Pre Tcosts)

250%
Min Var

200% 150% 100% 50% 0% -50%

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Looking at the sources of return and risk from the factors in our risk model (Figure 3), Scherers findings are confirmed namely that the average market beta is very low at 0.48, and most of the return comes from stock specific sources. Interestingly, the average exposure to Earnings Quality is very high at 0.93 which represents the beta of the MinVar portfolio returns to the Earnings Quality factor returns (constructed as the spread between the log cap. weighted performance of the top 500 and bottom 500 stocks in the S&P 1500 ranked by Earnings Quality score). Despite the high exposure to Earnings Quality, this factor contributes very modestly to risk which highlights the risk-dampening effect of a tilt to the Earnings Quality style factor. Also as we would expect, the portfolio has negative exposure to the Volatility style.

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Figure 3: Base Case MinVar Attribution (Pre Transaction Costs), Apr 2008 Oct 2010
Percent Realized Realized Realized Ann. Contribution of Contribution Percent of Return/Risk Portfolio to Portfolio Portfolio to Portfolio Portfolio Ratio Return Risk Risk Risk Risk

Portfolio Exposure

Factor Market Styles Value Size Analyst Expectation Historical Growth Capital Efficiency Price Momentum Earnings Quality Volatility Industries Stock Specific Grand Total

0.48 -0.08 -0.17 0.01 -0.03 -0.21 -0.12 0.93 -0.27 0.02 0.000

1.96% 2.11% -0.58% 0.82% 0.18% -0.28% 0.07% -0.18% 0.46% -0.94% -0.71% 0.43% 4.07% 6.02%

10.16% 9.09% 3.04% -0.58% 0.41% 0.58% 0.94% 1.15% -0.30% 2.27% 1.34% 3.36% 3.06% 10.61%

89.67% 70.37% 9.21% -0.79% -0.30% 0.35% 1.24% 0.81% -0.24% 5.11% 3.03% 10.10% 10.33% 100.00%

9.63% 8.44% 3.11% -0.98% 1.04% 0.94% -0.46% 2.27% 2.03% 0.85% -1.07% 3.45% 5.99% 11.35%

72.09% 55.35% 7.49% -0.74% 0.84% 0.68% -0.16% 4.01% 3.19% 0.56% -0.89% 9.25% 27.91% 100.00%

0.20 0.25 -0.19 -0.84 0.17 -0.30 -0.15 -0.08 0.23 -1.11 0.66 0.12 0.68 0.53

We also ran the style analysis using the Fama-French 3-factor model of Market, Size and Value excess returns. The results are presented in Figure 4 and from that we find that the Market and Value (but not Size) loadings were statistically significant at the 95% level in explaining the returns of the Base Case MinVar portfolio. The Market beta was about the same as when using the CIQ risk model at 0.5 while the exposure to Value was positive which is consistent with the results of Scherer (2010). We ascribe the difference in exposures to the Fama-French vs. CIQ Value factors to the more complex CIQ factor definition and to the presence of the other CIQ style factors. Figure 4: Regression Results - Base Case MinVar vs. Fama-French 3 Factor Model Returns Dependent Variable Constant Market Excess Return SMB (Size) HML (Value) R-squared Beta 0.130 0.500*** 0.052 0.215*** 0.597 Std Error 0.175 0.035 0.047 0.049 P-value 0.459 0.000 0.271 0.000

Note: Variable significant at the 99% level is marked by ***. Other variables are not even significant at the 90% level.

Next we look at the sector and market capitalization allocation of the Base Case MinVar portfolio. Past findings suggest that minimum variance portfolios are large capitalization and tilted toward value. In comparing the MinVar portfolio to the S&P 1500, MinVar is heavily underweight the top capitalization decile while, on average, overweight decile two to five and neutral to the bottom half capitalization names. On average, the top capitalization decile still represents 34% of the MinVar portfolio by value, so MinVar is still mainly a large capitalization portfolio albeit heavily underweight the mega-cap. group as shown in Figure 5. Under allocating to the top capitalization decile is a key reason for the overall outperformance as the top capitalization decile of the S&P 1500 is by far the worst performing decile during this period. These results are not inconsistent with the lack of a statistically significant loading on the Fama-French Size factor given that the
1

The Fama-French factors were retrieved from Ken Frenchs website on Jan 15, 2011 http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html

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Fama-French universe is much larger than the S&P 1500 and doesnt capture the differences within the top 5 deciles of the S&P 1500 (perhaps an indication not to be blindly reliant on the Fama-French factor framework). Although not covered in detail in this paper, we have been able to closely mirror the overall risk-return profile of the Base Case MinVar portfolio using the S&P 500 as the universe which suggests that an overweight in the bottom 350 or so names of the S&P 500 is adequate for achieving the same performance as when drawing from the full S&P 1500. Figure 5: Base Case MinVar Capitalization Allocation

The Base Case MinVar portfolios sector allocation (Figure 6) is consistent with intuitive defensive sector plays such as over allocating to Consumer Staples and Utilities while under allocating to Technology and Financials. However, this is not a uniform picture over time as the volatility of different sectors change through market cycles. Utilities, for example, has alternated between being a low and average volatility sector during this period, and its weight in the MinVar portfolio has varied accordingly.

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Figure 6: Base Case MinVarSector Allocation

In summary, the risk and return profile of the Base Case MinVar portfolio is driven by low market exposure, relative underweight the top market capitalization decile, defensive sector plays, and a strong tilt toward Earnings Quality but no strong tilts to more traditional styles such as Growth or Value (notwithstanding the more simplistic result achieved with just using the Fama-French factors).

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In the Base Case scenario, the style and sector exposures were unconstrained. Now we move on to investigating the effect of implementing style and sector neutrality as well as specific style tilts as this may be more relevant to how managers would overlay minim um variance onto existing strategies. All other parameters and constraints of the original problem remain the same. Implementing Style Neutrality The results of imposing sector neutrality with respect to the S&P 1500 (not shown) is simply to push up the market exposure (as the portfolio now looks more like the market portfolio) which increases risk while return suffers as we cannot achieve enough allocation to the defensive sectors which outperformed during this period. In the case of strict style neutrality (to the CIQ Risk Model style factors), the problem is not always feasible, and we have to choose how to handle infeasibilities. One way is to let the constraints be soft and impose penalties for taking style exposure. However, this would make the results difficult to compare with the Base Case as the effect of the penalties would cloud the pure effect of style neutrality. Instead we choose to simply drop the style constraints in case the problem becomes infeasible. When we do this the average style exposures over the period still turn out to be close to zero, but significant style bets are being taken along the way in all directions, and this approach would probably not qualify as an overlay to an existing strategy. However, the performance is interesting in that this semi style neutral portfolio posts an annualized pre-transaction cost return of 7.6% compared to 6.0% in the Base Case, and the Return/Risk Ratio increases slightly to 0.56 from 0.53. The increase in return is driven by higher market exposure, less style exposure (the aggregate return contribution from styles is negative in the Base Case) and, perhaps incidentally, higher return contribution from industry factors. This leads us to investigate if we can construct feasible minimum variance problems with some degree of style neutrality. We do this by implementing tilts to certain styles that should be conducive to minimum variance, such as Value and Earnings Quality, while imposing style neutrality with respect to all other style factors in an effort to retain some of the attractive performance features of the style neutral case. We rationalize the style tilts as follows: In stable environments Value tilted portfolios intuitively should have limited downside (as they are already cheap) although may have more tail risk in value trap scenarios, and similarly, Earnings Quality tilted portfolios should have more of a downside buffer as demonstrated by the Base Case scenarios natural gravitation toward Earnings Quality exposure. We construct the style tilts as flexible tilts in that the lower constraint bound is set to zero with no upper bound. This way, the portfolio will load up on a varying amount of Value or Earnings Quality exposure as governed by the minimum variance objective.

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Figure 7: Base Case vs. Tilted MinVar Performance; Apr 1998 Oct 2010 Base Case MinVar Value Tilt MinVar Earnings Quality Tilt MinVar

Factor Contribution to Ann. Return

Market Market Exposure Return/Risk Ratio Value Earnings Quality Other Styles Industries Stock Specific TOTAL (Pre-Tcosts) Total Return/Risk Ratio TOTAL (Post-Tcosts) Total Return/Risk Ratio

2.1% 0.48 0.25 0.8% -0.9% -0.5% 0.4% 4.1% 6.0% 0.53 5.1% 0.45

2.8% 0.60 0.26 -0.2% -0.1% -0.1% 1.0% 4.6% 8.0% 0.60 6.9% 0.51

2.9% 0.58 0.29 0.2% -0.7% -0.2% 0.7% 4.5% 7.4% 0.58 6.3% 0.50

The pre-transaction cost returns of the tilted portfolios increase by 1.4% and 2.0% p.a. in the case of Earnings Quality and Value tilts respectively com pared to the Base Case (Figure 7). The outperformance is mainly due to (1) higher market exposure which results in higher return but not at the expense of markedly higher risk, (2) higher return contribution from industry factors, and (3) greater stock specific return. The total realized risk does increase compared to the Base Case as the market exposures of the tilted portfolios increase, but the total Risk/Return Ratios of the tilted portfolios easily outperform the Base Case as only the increased market exposures contribute modest additional risk. In the cases of both Value and Earnings Quality tilts, we are able to construct MinVar portfolios that take advantage of the return profile of style neutrality by loading up on market exposure without a proportionate increase in risk while maximizing industry and stock specific sources of return. The improved performance does not come from exposure to the style tilts themselves but from the combination of the tilts with style neutrality to the other factors. In Figure 8, on the next page, we show the various MinVar portfolios exposures to the market, Value and Earnings Quality factors over time. The market exposures of the two tilted portfolios are very similar, whereas the Base Case has consistently lower market exposure. Much of the market exposure effect comes from style neutrality as opposed to the specific tilts, e.g. for the Value tilted portfolio, there are effectively no tilts from 3/1/2009 while the market exposure hovers around 0.65. In part, the effect of the Value and Earnings Quality tilts is to allow the problem of style neutrality (to other styles) to become feasible, and in turn, the remaining style neutrality has an enhancing effect on MinVar portfolio performance compared to the Base Case.

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Figure 8: Market & Style Factor Exposures of MinVar Portfolios

It remains a somewhat open question exactly why style neutrality (in combination with specific style tilts) produces superior returns. To some extent, the sources of returns, by construction, have to be the factors other than the styles, i.e. the market and industry factors along with stock specific return. However, we would suggest that style neutrality is inherently consistent with minimum variance as investing in a well known, and at times popular, style with finite investment capacity is inherently more risky than avoiding such tilts. By extension, it is not surprising that style neutrality can be considered a refinement of the unconstrained minimum variance objective. Another takeaway from Figure 8 is that the Earnings Quality and Value tilts are not that highly correlated, so there appears to be several (if not many) different strategies for which minimum variance would be a functional overlay. It turns out that even a Price Momentum tilt is consistent with minimum variance when combined with a Value tilt and that the performance of this tilt combination is similar to those of the single factor tilts to Value and Earnings Quality respectively. In all these cases, it appears to be the neutrality to a majority of style factors that delivers pretransaction cost annualized returns of 7.4-8.0% with around 13% annual risk. Interestingly, the minimum variance portfolio construction process can be helpful in identifying which style bets are most attractive at any point in time. Figure 9 shows the Price Momentum and Value exposures that result from the MinVar portfolio with flexible tilts to both Price Momentum and Value.

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Figure 9: Style Factor Exposures of Value & Price Momentum Tilted Portfolio

As the above figure shows, the exposures have ICs of 0.08 and 0.13 with respect to 1-month forward factor returns of Price Momentum and Value respectively but only the Value exposure IC is statistically significant at the 95% while the Price Momentum exposure IC is only statistically significant at the 84% level.

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Portfolio construction with a minimum variance objective naturally lends itself to large-cap. but not mega-cap. portfolios. The Base Case MinVar portfolio without sector or style constraints appears difficult to beat in terms of realized risk as the effect of imposing sector or style constraints uniformly increases risk through increased market exposure. Sector neutrality in particular seems to be incongruent with the minimum variance objective. However, style neutrality appears to have a positive effect on realized performance of the MinVar portfolio particularly when combined with certain style tilts. Partial style neutrality combined with single factor tilts to Value or Earnings Quality increases the returns of the MinVar portfolio at the expense of a relatively modest increase in risk compared to the Base Case. Even tilts to a relatively high volatility factor such as Price Momentum can, when combined with a Value tilt and style neutrality to the remaining styles, generate performance similar to the more intuitive single factor tilts. In turn, it appears that minimum variance can be implemented as an overlay to a fairly wide variety of existing strategies while improving on the attractive risk -return profile exhibited in the Base Case scenario. We summarize the performance of the various MinVar cases in Figure 10. Figure 10: Summary of MinVar Spreads against S&P 500 Total Returns (Pre-Tcosts)

As a side-effect, it also appears that the minimum variance portfolio construction process can give useful input to factor switching strategies, at least as concerns Value and Price Momentum. Other than imposing liquidity constraints and presenting some post transaction cost results, we havent focused a great deal on turnover, but the minimum variance strategies presented in this paper are inherently high turnover with annual two-way turnover of the order of 225-300%. Turnover can of course be managed through additional constraints, but this will likely affect performance. It is clear that the success of the minimum variance strategy is regime dependent, and the technology bubble run-up was clearly not the right regime for this strategy. Having said that, if you believe that we are not in an environment where exuberance is richly rewarded, there appears to be many ways of incorporating the benefits of minimum variance into todays strategies. It should also be noted that while other risk models may be able to replicate some of the results in this paper, the ability to implement style constraints to a comprehensive set of risk factor styles which include alpha factors as well as traditional risk factors, as far as we know, is not supported by any other commercial vendor.

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Capital IQ US Fundamental Risk Model: We use our in-house risk model for portfolio construction and ex-post attribution. The key differentiator of our risk model is that it is based on the Capital IQ Alphaworks factor library which contains in excess of 400 thoroughly researched indicators. The risk model uses 130 of these aggregated into 8 style factors which reflect the typical building blocks used by managers for alpha generation and portfolio construction (Figure 11). Figure 11: Risk Model Style Factors

Style Factor
Analyst Expectation

# of Indicators

Representative Factors
Earnings & Sales Forecast Earnings Surprise Analyst Diffusion Analyst Revision Return on Equity & Capital Leverage & Interest Coverage Issuance & Buybacks Balance Sheet Accruals Working Capital & Asset Turnover Capital Expenditure and R&D Intensity Margins, Payout Ratio 1 & 3-year growth of o Operating & Free Cash Flow o Earnings o Margins 1, 6, 9 & 12-Month Price Momentum Technical indicators over various time frames e.g. MACD, RSI, Slope, 52 Week High/Low Log of Market Cap. & Sales Reported & Forward Earnings Yield Dividend Yield Book to Price Sales, EBITDA & Cash Flow to Enterprise Value Inverse PEGY Realized volatility CAPM Beta Distance from High to Low (1 & 12 months) Short Interest & Trading Volume

11

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10

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26

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31

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20 2

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Volatility

These style factors lend themselves better than typical vendor provided models to making portfolio attribution relevant to existing investment processes. In the case of the MinVar portfolio, the Earnings Quality style is very relevant as we saw earlier. In addition to the factors in Figure 11, the risk model has a market factor and 24 GICS level 2 industry factors. The risk model is constructed such that market and style factors take precedence over industry factors to the extent that they are correlated. The model is based on daily data with serial correlation adjustment and is very responsive to structural changes in volatility (Figure 12). The model comes in two versions, Short Term which is calibrated to a 1-3 month forecast horizon and Medium Term which has a 6-12 month horizon. We use the Medium

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Term model for this particular exercise with a view to limiting turnover. There is a separate white paper available by Scherer/Balachander/Falk/Yen (2010) which covers our US Fundamental Risk Model in detail.

Figure 12: Forecast and realized 1-month volatility (annualized) of the S&P 500

90.0% 80.0% 70.0% 60.0% Realized Forecast

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ClariFI Mean Variance Optimizer: The MinVar portfolios are constructed using our optimizer with the objective of minimizing risk at each rebalancing with reference to the risk model and the various constraint sets that we shall describe. Our Mean Variance Optimizer is a state of the art solver for Mixed Integer Quadratically Constrained Quadratic Programming problems and has an extensive feature set: Risk (and tracking error) can be in the objective function or treated as constraint. Multiple risk terms/models supported Constraints can be hard, hierarchical or soft with penalties (linear or quadratic) including o Holding size constraints o Cardinality constraints (min/max position counts) o Trading constraints including % of ADV and threshold holding and trade size o Exposure constraints, e.g. to sectors or risk model factors Full long-short capabilities Transaction cost model support Integrated with back-testing engine

Capital IQ ClariFI Portfolio Attribution Framework: We are launching in ClariFI and on the Capital IQ Platform a factor based attribution tool to analyze factor contribution to forecast and realized risk as well as realized return. All the factor attribution tables and charts in this paper have been produced with this tool.

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REFERENCES Ang, Andrew, Robert J. Hodrick, Yuhang Xing & Xiaoyan Zhang (2006), The crosssection of volatility and expected returns, Journal of Finance, Vol. LXI, No. 1, February 2006, pp. 259299 Blitz, D., & Vliet, P. (2007). The volatility effect: lower risk without lower return. Chan, L., J. Karceski, and J. Lakonishok (1999), On portfolio optimization: Forecasting covariances and choosing the risk model, Review of Financial Studies, 12, 937-974. Clarke, Roger, Harindra de Silva & Steven Thorley (2006), Minimum-variance portfolios in the US equity market, Journal of Portfolio Management, v33, pp.10-24 Fama, Eugene F., and James D. MacBeth (1973), Risk, return and equilibrium: Empirical tests, Journal of Political Economy 71, pp. 43-66 Haugen, R.A, and N.L. Baker (1991), The efficient market inefficiency of capitalization-weighted stock portfolios, Journal of Portfolio Management No. 3, pp. 35-40. Jagannathan R. and T. Ma (2003). Risk reduction in large portfolios: Why imposing the wrong constraints helps. The Journal of Finance, 58(4), 1651-1684. Scherer, Bernd. (2010). A Note on minimum variance investing, Available at SSRN: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1681306 Schwartz T. (2000). How to beat the S&P 500 with portfolio optimization, working paper, DePaul University

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