Successful investing requires appropriate asset allocation and sticking to an investment strategy amid turbulent markets. Volatility can unnerve some investors to an extent that jeopardizes long-term goals. A portfolio’s mix of stocks, bonds and other investments is an important factor in its performance. A diversified portfolio should also include an exposure to international and emerging market stocks. Once this balance is achieved, investors must then adhere to their strategy. Volatility often drives emotions that can cause investors to buy at the highs and sell at the lows. Emotional investment decisions generate inferior results when compared with the performance of an index like the Standard & Poor’s (S&P) 500.
Recent studies show that the market is becoming more volatile. The goal is to create an investment strategy that minimizes the risk of volatility while still obtaining market-like returns. Low volatility funds can instill the confidence that helps investors stay invested during the ups and downs of the market. Investment vehicles like the iShares MSCI EAFE Minimum Volatility Fund (EFAV) are designed to capture a meaningful percentage of upside swings while limiting downside exposure as much as possible.
Fund Overview
iShares MSCI EAFE Minimum Volatility Fund provides defensive exposure to large- and mid-cap stocks listed in developed Europe, Asia and Australia. The goal of EFAV is to offer a more favorable risk/reward profile than the broader market-cap-weighted MSCI EAFE Index. The fund invests at least 90 percent of assets in components of the underlying benchmark. Although the fund should lag its benchmark during rallies and hold up better in a down market, EFAV has outpaced the benchmark from its inception in 1988. With 78 percent less volatility, it is a suitable core holding for conservative investors.
Fundamental View
This low-volatility fund has a tilt toward stocks with high profitability and low valuations, which are characteristics historically associated with better-than-average returns. First documented in 1972, this low-volatility effect results in stocks with low betas, or sensitivity to market fluctuations, which generate better returns relative to their risks when compared with stocks with higher betas. A similar relationship was found for a portfolio consisting of low-volatility stocks. Rather than substitute bonds for equities to reduce volatility and limit losses, low-volatility stocks are used. These stocks reduce downside risk but still have the potential for greater returns during a rising market than does a stock/bond portfolio with similar volatility.
Investment Strategy
Fund managers seek to replicate the performance of the MSCI EAFE Minimum Volatility Index. This underlying benchmark attempts to create a portfolio of the least volatile stocks in the MSCI EAFE Index. The investment strategy utilizes the Barra equity risk model to estimate each stock’s volatility, its sensitivity to various risk factors like valuations and the correlation between them. A proprietary algorithm sorts the data to select the optimum investments and weightings that should produce the lowest volatility based on several constraints. These include keeping sector and country weightings within 0.05 and 1.5 percent of those in the MSCI EAFE Index. One-way turnover is also limited to 10 percent. These constraints improve diversification, enabling the fund to be used as a core holding. The strategy assumes that past volatility and correlations will continue in the short term, which has been the case historically. The index portfolio is reconstituted semiannually.
Portfolio Construction
In contrast to the MSCI EAFE Index, the investment strategy has created a portfolio with higher exposure to defensive sectors, such as consumer defensive, health care, telecom and utility stocks. The portfolio also has less exposure to the financial, energy and technology sectors. The fund is weighted toward Japan and the United Kingdom and underweight the eurozone based on its recent volatility. Risk is mitigated by holding more than 200 separate securities and limiting the exposure of the top 10 holdings to less than 15 percent of assets under management. Top holdings include Unilever, GlaxoSmithKline PLC and Swiss Re. Although the portfolio has a smaller average market cap than the MSCI EAFE Index, it generated slightly higher returns on invested capital over the trailing 10-month period ending April 2016.
Fees
The fund has a reasonable 0.20 percent expense ratio. Even though it is engaged in a more dynamic investment strategy, the fund’s expense ratio is not much higher than that of the cheapest market-cap-weighted alternative. The cap on turnover limits trading costs. BlackRock also engages in securities lending as a way to generate ancillary income that can partially offset expenses. Over the past three years, the fund has trailed its benchmark by six basis points.
Alternatives
The closest alternative to EFAV is the PowerShares S&P International Developed Low Volatility Fund (IDLV). This fund uses a simplified ranking system for international stocks based on their 12-month trailing volatility. Stocks in the lowest quintile are selected and then weighted based on the inverse of their individual volatility. As result, the least volatile stock receives the highest weighting within the portfolio, which is rebalanced quarterly. Because IDLV does not place restrictions on country or sector weightings, the fund can make concentrated investments. Unlike EFAV, the fund invests in Canadian stocks and does not have a turnover limit. IDLV has a slightly higher 0.25 percent expense ratio.
Another comparable option is the iShares MSCI All Country World Minimum Volatility ETF (ACWV), which applies the low-volatility investment strategy to a portfolio of global stocks. This ETF employs the same investment methodology as EFAV, while also including securities from emerging markets as well as the United States and the rest of the developed world. ACWV has a higher 0.34 percent expense ratio.
A third alternative is the Vanguard Global Minimum Volatility Fund (VMVFX). Similar to ACWV, it utilizes a strategy that optimizes correlations and stock volatility when constructing the portfolio. In addition to hedging its currency exposure to further reduce volatility, VMVFX includes domestic and foreign stock allocations. Unlike EFAV, this fund does not track an underlying benchmark index. This gives managers greater flexibility in stock selection, weightings and holding times, which lowers trading costs while providing the ability to wait for an investment to pay off. The fund’s Admiral Class shares have a 0.20 percent expense ratio and require a $50,000 minimum investment. Smaller investors can purchase Investor Class shares that have a 0.30 percent expense ratio with a $3,000 minimum initial investment.
iShares MSCI EAFE Minimum Volatility ETF (EFAV) offers an alternative to broader, more volatile international funds, with the potential for higher yield. While market conditions do not warrant increasing international exposure or reducing bond exposure in favor of the fund, it may be a favorable replacement for ETFs in the same category.
Fund Spotlight: iShares MSCI EAFE Minimum Volatility Fund (EFAV)