Investment Philosophy

Market cap-weighted indices are NOT efficiently constructed

A market cap-weighted index is not an efficient portfolio. Individual investments are weighted according to size: stocks according to market value (market capitalisation) and bonds according to debt (issuance volume). Size-weighted methods make no reference to return and risk. Scientific studies also show: the index lies clearly below the efficient frontier, on which optimal portfolios lie. The index does not have an optimal return-risk ratio (Sharpe ratio). Conclusion: There are more efficient portfolios with less risk and more return.

Efficient Investing with the OLZ minimum variance portfolio

The idea behind the OLZ investment philosophy is to improve the portfolio composition within an asset class. The optimal weighting of individual investments is determined on the basis of predicted risk parameters (volatilities, correlations). In the process, OLZ takes into account the latest findings in financial market research. Systematic optimisation of a portfolio improves its diversification and efficiency (less risk, higher return).

The goal is the ex-ante minimum variance portfolio with the following advantages:

Less risk thanks to optimised diversification

The ex-ante minimum variance portfolio lies closer to the efficient frontier and has a better return-risk ratio (Sharpe ratio) than the index. Optimised diversification provides a lower portfolio volatility and significantly lower losses in the course of market corrections.

Higher return due to the low volatility premium

Empirical financial market studies confirm that stocks with lower price fluctuations (volatility) achieve above average returns. The low volatility premium has been documented for over 40 years. It can be optimally implemented using the minimum variance portfolio because correlations between individual investments are also taken into consideration.

Minimum variance portfolios can be estimated

The minimum variance portfolio is the only portfolio on the efficient frontier dependent only on risk parameters which can be modelled and predicted over time with econometric methods. Return estimates are not required.

Sustainability (ESG)

OLZ takes into account environmental, social and governance (ESG) criteria in the investment process. Companies which do not meet the following ESG criteria are thus excluded from the investment universe:

  • Recommendations for exclusion from the Swiss Association for Responsible Investments (SVVK-ASIR)
  • Companies which do not meet UN Global Compact criteria
  • Companies which have received the lowest ESG-rating «CCC» from MSCI
  • Companies with a «red flag» on the MSCI Controversies list

Further, sustainability ratings are also taken into account at overall portfolio level. Thus, OLZ funds have a minimum rating of «A».


How can the low-volatility factor premium be explained?

The low volatility premium (above average return from equities with low volatility) has been observed in the market for over 40 years. This market anomaly exists because the majority of investors are benchmark oriented. Market cap-weighted indexing is popular standard practice despite the fact that this investment behaviour does not lead to an efficiently diversified portfolio. Investing close to index minimises tracking error. Managers only tend to deviate from the benchmark when the reward (expected return) is significantly higher. This is why stocks with higher risk - high beta stocks - are favoured (overweighted), and stocks with low volatility are neglected (underweighted). As a result, low volatility stock prices fall and their expected returns rise, which contributes to the low volatility premium. In recent years, the trend towards passive implementation of the market cap-weighted index has in fact increased the low volatility premium.

Can a minimum variance portfolio be characterised by 'value'?

Scientific studies confirm that minimum variance portfolios do not correlate with the value factor. Low volatility and value are two complementary factor premiums. The two investment styles can be combined, and together they yield a robust alpha compared to the market cap-weighted index.

Will the low volatility premium persist?

Generally, the structures and processes to which institutional investors are subject only permit slow changes. It takes advanced know-how, courage and strong governance not to follow the herd but instead, to stray from standard behaviour. Developments in recent years show that more and more investors - both institutional and private - invest according to the standard index or the average portfolio. The standard behaviour of the majority - replicating the market cap-weighted index - means that the low volatility premium does not disappear. In fact, it can be observed that the premium is increased by this behaviour.

What if all investors were to invest according to the minimum variance portfolio?

If all investors were to invest in the minimum variance portfolio, the excess return (low volatility premium) would disappear. However, the portfolio would still be composed more efficiently and with better diversification than the market cap-weighted index. With the same expected return, an investor who invests in a minimum-variance portfolio would benefit from significantly lower volatility and fewer losses from market corrections.

Could a minimum variance portfolio lead to extreme solutions?

When optimising, maximal limits for individual stocks, countries and sectors (known as restrictions) are taken into consideration, thus avoiding concentrations. Compared to standard 'minimum variance' indices such as the MSCI Minimum Volatility Index, OLZ minimum variance portfolios have considerably more degrees of freedom. For example, OLZ does not use minimal weights.

Does including sustainability criteria lead to lower returns?

No. The risk-return characteristics of our strategies are not affected by the implementation of sustainability criteria in the investment process. Sustainability can be implemented particularly well with a risk-based investment approach such as OLZ minimum variance: It does not lead to a decline in returns nor does it weaken the investment approach: The investment universe remains sufficiently large, especially since companies whose share prices only fluctuate a little are often also prudently managed. In short, minimum variance and sustainability harmonise optimally. Further information on the integration of sustainability criteria can be found in our OLZ research note: «Minimum Variance - a Harmonious Relationship».