We have recommended Vanguard’s Global Minimum Volatility Fund (VMVFX) for quite some time. The fund utilizes a number of beneficial strategies, such as low volatility and currency hedging, while taking a global approach to equities. This results in a solid core holding for investors looking for international exposure amid a U.S. dollar rally. This month we are going to reevaluate VMVFX and see how it has performed over the past year to determine whether it is likely to be a good investment over the months ahead.
Historic Dollar Rally
Over the past year we have seen one of the largest U.S. dollar rallies since the currency became untethered from gold in 1973. The U.S. Dollar Index has 57.6 percent of assets in the euro, plus 13.6 percent in the yen, 11.9 percent in the pound, 9.1 percent in the Canadian dollar, 4.2 percent in the Swedish krona and 3.6 percent in the Swiss franc. The index has climbed from 80 in July 2014 to over 100 in March, before settling into the 90 range more recently. This 25 percent advance in our currency has been fueled by Europe’s decision to launch a quantitative easing program in January, a move that was anticipated for months before the announcement. More recently, weakness in China weighed on the Canadian dollar, while Japan’s consistent policy of currency devaluation since 2012 has benefited the greenback.
As a result of recent market changes, various international funds faced currency headwinds of varying strength. For example, Vanguard European Stock (VGK) slipped 7.98 percent over the past year. WisdomTree European Hedged Equity (HEDJ), which hedges out currency exposure, gained 5.93 percent. The gap of 13.91 percent was largely explained by the drop in the euro, which fell 15 percent over the same period.
Vanguard Global Equity (VHGEX) has fallen 5.24 percent over the past year, while VMVFX has gained 8.88 percent. The gap of 14.12 percent more closely approximates the gain in the U.S. Dollar Index. About half of each fund is invested in the United States, while the remainder is invested overseas. If one were to assume the only difference between the two portfolios was currency hedging, the expected difference would roughly approximate the currency changes on the overseas half of the portfolio, or approximately 12 percent. In this case, VMVFX performed better than the currency changes alone would predict.
The performance gap over the past year illustrates the appeal of VMVFX. The fund will outperform during a U.S. dollar bull market, and the bulk of its gains will come through the avoidance of currency losses.
VMVFX
Low volatility indexes are similar to other broad market indexes, but focus on the volatility of individual stocks. This can create a potentially risky portfolio due to sector concentration, as sectors such as utilities have lower than average volatility. Overall, the portfolio would have a lower degree of volatility on paper, but if there were a sector specific event, the portfolio could experience much higher than anticipated losses. VMVFX aims to remove this risk; managers examine the correlation between individual stocks in the portfolio and adjust exposure in order to deliver a more diversified portfolio.
When considering a low volatility fund, it is important to remember that volatility is a measurement of only one type of risk. A low volatility fund is expected to fluctuate less than a high volatility fund, but it isn’t going to buck the overall market’s trend. If stocks are headed higher, the low volatility fund will move higher; if stocks are falling, it will fall too. This risk is called market risk, and it is represented by beta. Generally speaking, we can say a low volatility fund is expected to fluctuate less than a regular index fund, but whether it performs better or worse will depend on other factors such as sector exposure.
Low volatility became a popular investment strategy in recent years as research indicated that low volatility stocks, though not favored by investors, performed better than the market as a whole. Tobacco stocks such as Altria Group (MO) were shunned by investors for ethical reasons but, despite their businesses being steady and monotonous, persistently outperformed the stock market for decades. There are many such uninspiring companies in the stock market – firms that are in the same line of business with no major expansion plans, technological breakthroughs or aggressive growth strategies. Many investors look to strike it rich, searching for “hot stocks” – companies launching new products, entering new markets or creating new technology. This leads to an undervaluation of low volatility companies while stocks with higher volatility are prone to overvaluation.
VMVFX is well diversified, with the largest sector (healthcare) responsible for less than 17 percent of assets. That is roughly in line with major indexes such as the S&P 500 Index. In contrast, some low volatility funds have well over 20 percent of their assets in utilities, while VMVFX has only a small weighting of 7 percent in the portfolio.
While VMVFX is actively managed, the expense ratio is a reasonable 0.30 percent. The fund is not tax efficient due to the high turnover rate required to maintain its minimum volatility mandate. VMVFX also hedges currency exposure, which can be beneficial when the U.S. dollar is strong, but could lead to underperformance during periods of weakness. Investors who hope to maximize the upside from this fund will want to consider the overall trend in the U.S. dollar. The bulk of the difference in performance between this fund and the average global fund will come down to the direction of the U.S. dollar.
Conclusion
Global Minimum Volatility (VMVFX) performed exceptionally well over the past year. The fund’s currency hedging paid off handsomely as the U.S. dollar experienced a historic rally, one of the largest in the past 40 years. In the past few decades, the U.S. dollar has experienced bull and bear cycles of roughly six years’ duration. The rally to this point is barely more than one year old and, for investors looking for overseas exposure, hedging out foreign currency risk amid a U.S. dollar rally could meaningfully impact returns to the upside. We will continue to recommend this fund as it provides excellent returns and sound management at a low cost.