Promising alternative to FTSE trackers

Some things in finance don't make sense, but exist nevertheless. One long-standing anomaly is the low-volatility effect'. All else being equal, you'd expect the riskiest stocks those with the most volatile share prices to have the highest long-term returns. Otherwise, there would be little reason to buy them the reward wouldn't compensate for the risk involved.

Yet evidence suggests that actually it's the least volatile shares that offer the highest long-term returns. Of course, this may just be one of those trends that everyone starts to notice just before it ends. "Small stocks always outperform larger ones" and "stocks always go up in the long run" has proved costly advice to those who joined the party late.

But those highlighting the anomaly may have a point. It may exist because momentum-chasing active fund managers tend to focus on the same stocks in an effort to beat their benchmarks (and each other).

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But as such short-term effects fade, it's the share-market tortoises that get to outperform the hares in the end. One of the latest exchange-traded funds (ETF) aiming to exploit this low volatility effect is Ossiam's FTSE 100 minimum variance ETF (LSE: UKMV).

Ossiam takes the FTSE 100's members and uses the last two years of history to measure both individual stocks' volatility and the correlations between them. The index stocks are then re-weighted to minimise the overall volatility. To ensure diversification, there are limits on the amount that can be held in a single stock or sector.

Currently, after this optimisation' process, the overall weighting of oil and gas, basic materials and financial stocks in the FTSE 100 falls by more than 30%, while consumer services, industrials and utilities stocks get an equivalent boost. The fund charges 0.45% a year in fees and there's likely to be an extra 0.25% a year performance drag from stamp duty on share purchases.

However, according to Ossiam, back-testing suggests that over the last ten years, its index has beaten the average annual return on the FTSE 100 of 4.2% by more than 5% a year. Now it's right to be sceptical of back-tests the strategy would probably underperform in a momentum-driven market. But the minimum variance approach is an interesting one and this looks like a promising alternative to the standard FTSE trackers.

Paul Amery edits www.indexuniverse.eu , the top source of news and analyses on Europe's ETF and index-fund market.