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White papers

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Minimum-Variance Portfolios in the U.S. Equity Market
Firm: Analytic Investors
Authors: Roger Clarke, Harindra de Silva and Steven Thorley
Overview: Reducing volatility without sacrificing returns. The concept of an efficient frontier has been a mainstay of financial economics and to some extent portfolio management practice since the 1960s when modern portfolio theory was first articulated. The basic Markowitz (1952) prescription is to estimate expected returns and a covariance matrix for individual securities and then to minimize the portfolio's ex ante risk for any given expected return by adjusting security weights.

Know Your VMS Exposure
Firm: Analytic Investors
Authors: Roger Clarke, Harindra de Silva and Steven Thorley
Overview: One of the ongoing debates in equity market research is the set of common factors that explain the cross section of individual stock returns. With the influential backing of Fama and French (1993), a three-factor model that includes the market, size and value factors is frequently cited in academic research and widely used in portfolio management. More recently, momentum has joined the list of accepted factors, resulting in references to a four-factor model. Discussions in these factors do not always distinguish between their role in explaining the cross-sectional variation in average returns and their role in explaining risk, although both issues are important to portfolio management.

Minimum-Variance Portfolio Composition
Firm: Analytic Investors
Authors: Roger Clarke, Harindra de Silva and Steven Thorley
Overview: The performance of equity portfolios optimized to have the lowest possible variance has attracted investor attention over the last several years. Minimum-variance strategies address an increased appreciation for risk management due to the financial crisis, as well as to the historical fact that low-volatility stocks tend to have returns that meet or exceed the market. The empirical observations that high-market-beta stocks are not rewarded with correspondingly higher returns is a long-standing empirical critique of the CAPM.

Low Volatility Equity Portfolios: A Free Lunch
Firm: Analytic Investors
Authors: Roger Clarke, Harindra de Silva and Steven Thorley
Overview: "Free lunches" are rare and perhaps non-existent in the investment markets. However, savoring an almost free-lunch can be nearly as rewarding to long-term investment success. Our research into minimum variance equity portfolios identifies a return/risk anomaly that may well be an investment bargain.

VMS: A New Factor in Portfolio Analysis
Firm: Analytic Investors
Authors: Roger Clarke, Harindra de Silva and Steven Thorley
Overview: Since 1993, the list of common equity risk factors has expanded to include market, small-cap, value and momentum. Building on our 2006 research that showed on average low-volatility stocks perform as well as high-volatility stocks, we have created an additional factor that measures the payoff from volatility (VMS). Our investigation finds that VMS is more influential on equity returns than size and value and ranks as important as momentum. Additionally, we believe it is important for investors to understand their portfolios' exposure to VMS in order to understand the sources of returns and manage the overall risk of their equity investments.

Winning by not Losing: An introduction to low-volatility equity strategies
Firm: Mercer
Overview: In our Constructing a Better Global Equity Portfolio paper, we advocated constructing a portfolio that had strategic over-allocations to those parts of the equity market (emerging markets and smaller companies) that, over the long term, were expected to deliver higher rates of growth and higher returns. Recognizing that these markets also brough higher risk - in the form of volatility of returns - we stated that these strategic allocations should be counterbalanced by an allocation to a low-volatility component of the portfolio, in order to bring the overall volatility of the combined portfolio more broadly in line with conventional market capitalization-weighted index benchmarks.

Benchmarks as Limits to Arbitrage: Understanding the Low Volatility Anomaly
Firm: Acadian Asset Management LLC
Authors: Malcolm Baker, Brendan Bradley, and Jeffrey Wurgler
Overview: Contrary to basic finance principles, high-beta and high-volatility stocks have long underperformed low-beta and low-volatility stocks. This anomaly may be partly explained by the fact that the typical institutional investor's mandate to beat a fixed benchmark discourages arbitrage activity in both high-alpha, low-beta stocks an in low-alpha, high-beta stocks.

Defensive equity: Is the market mispricing risk?
Firm: Russell Investments
Authors: Bob Collie, FIA, Chief Research Strategist, Americas Institutional
John Osborn, CFA, Director, Consulting, Americas Institutional
Overview: Intuitively, investors might expect stocks that are less risky than other stocks - stocks we refer to as defensive stocks - to deliver lower returns than the broad market over the long term. That does not seem to have been the case, however. Among the factors that have been suggested as contributing to this apparent anomaly is the widespread use of market-relative benchmarking by mutual funds and institutional accounts. For investors who expect this defensive effect to persist, the strategy offers the possibility of a reduction in portfolio risk and a more attractive trade-off between risk and reward.

The Third Dimension of Style: Introducing the Russell Stability Indexes
Firm: Russell Investments
Author: Dave Hintz, CFA, Head U.S. Equity Research, Investment Division
Overview: In 1984 Russell, a multi-manager investment firm, emerged as a leader in the creation of indexes for U.S. equity markets with the introduction of its Russell 1,000 (U.S. large cap) and Russell 2,000 (U.S. small cap) Indexes - transparent, rules-based indexes that accurately define the dimensions of U.S. market-cap segments and serve as reliable benchmarks for the evaluation of active equity managers' performance. Three years later, Russell pioneered style indexes when it launched the Russell 1,000 Growth and Value Indexes, which grew out of the insights gained in its research into additional dimensions of U.S. market segmentation and manager investment styles. Russell's expertise in manager research gave insights into equity markets and investment manager behavior that has driven the development of the Russell U.S. Indexes. Now Russell's research into markets and managers has led to the identification of another dimension of style: stability.