Minimum Variance Portfolios

Eric Falkenstein is probably the financial blogosphere’s biggest advocate of Minimum Variance Portfolios (MVP). The idea is that in investing risk and reward are not trade-offs. In fact, the lower the risk, the higher the reward. As counter-intuitive as this sounds, the numbers back it up.

Falkenstein has shown that a portfolio constructed of the lowest-risk stocks in the S&P 500 has outperformed the index. I got the data off his site and here are the returns since 1998:

Since the beginning of 1998 through August 2011, the S&P 500 has returned 31.59% while the Minimum Variance Portfolio has returned 211.18%. Annualized, that’s a lead of 8.7 to 2%.

But here’s the kicker: the MVP has accomplished this with…well, minimum variance.

Get ready for some math.

In the table below, the blue dots indicate all of the daily changes in the chart above. The X-axis is the changes in the S&P 500. The Y-axis has the changes for the MVP.

The key is that the MVP doesn’t go as high as the S&P 500 during an up day, nor does it fall as low as the index during a down day. I added the diagonal red line to show the 1-to-1 divide.

Notice how the blue dots fall below the red line in the upper right quadrant and above the red line in the lower left quadrant. That’s what MVP is all about.

The black is the linear trend and the formula is the classic linear equation (y=mx+b). The slope of the trend line is 0.558. What this means is that for every one unit the black line moves to the right, it climbs by 0.558 units, and for every one unit it falls, it drops by 0.558 units.

In finance speak, that’s the beta of the portfolio, 0.558. If a portfolio has a beta of 1.0, it exhibits the same variance as the S&P 500. If it’s greater than 1.0, the portfolio swings greater than the market.

Historically, our Buy List has a beta of 0.94.

The b in the equation is the y-intercept, meaning that’s where the trend crosses the Y-axis when x=0. But more importantly for us, this also tells us how well the MVP has done against the S&P 500. Since it’s positive, the MVP has beaten the market by an average of three basis points per share, or 0.03%. (It’s actually about 2.5 basis points but Excel rounded up.)

So despite having nearly half the variance as the overall market, the MVP has crushed the S&P 500 over the 13 years years.

If you’re interested in learning more, here’s a link to Eric’s book, Finding Alpha: The Search for Alpha When Risk and Return Break Down. And here are the 47 stocks currently in the MVP (it’s rebalanced every six months):

Company Symbol
3M CO MMM
ABBOTT LABS ABT
AMERISOURCEBERGE ABC
BAXTER INTL INC BAX
BECTON DICKINSON BDX
CAMPBELL SOUP CO CPB
CEPHALON INC CEPH
CLOROX CO CLX
COCA-COLA CO KO
COLGATE-PALMOLIV CL
CONAGRA FOODS CAG
CONS EDISON INC ED
CR BARD INC BCR
DOMINION RES/VA D
DUKE ENERGY CORP DUK
DUN & BRADSTREET DNB
GENERAL MILLS IN GIS
GENUINE PARTS CO GPC
HJ HEINZ CO HNZ
HOSPIRA INC HSP
IBM IBM
INTEGRYS ENERGY TEG
JM SMUCKER CO SJM
JOHNSON&JOHNSON JNJ
KELLOGG CO K
KIMBERLY-CLARK KMB
KRAFT FOODS INC KFT
KROGER CO KR
L-3 COMM HLDGS LLL
LABORATORY CP LH
MCCORMICK-N/V MKC
MCDONALDS CORP MCD
MEDTRONIC INC MDT
MILLIPORE CORP MIL
PEPSICO INC PEP
PFIZER INC PFE
PINNACLE WEST PNW
PROCTER & GAMBLE PG
PROGRESS ENERGY PGN
QUEST DIAGNOSTIC DGX
RAYTHEON CO RTN
REYNOLDS AMERICA RAI
SOUTHERN CO SO
WAL-MART STORES WMT
WATSON PHARM WPI
WISCONSIN ENERGY WEC
XCEL ENERGY INC XEL

Posted by on September 28th, 2011 at 4:58 pm


The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.