Low Volatility Abroad

In the context of investing, volatility usually isn't a good thing. Sure, in theory, the market should compensate investors with higher expected returns for accepting greater risk that cannot be diversified, but it hasn't always turned out that way in practice. Historically, the most volatile stocks and bonds have offered the lowest risk-adjusted returns, according to a study by AQR principals Andrea Frazzini and Lasse Pedersen. In other words, incremental increases in risk have not been matched with commensurate improvements in return. More problematically, volatility tends to encourage the perverse tendency that investors have to buy high and sell low. It may also deter investors from adequately diversifying into international stocks. 

While international stocks tend to be more volatile than their U.S. counterparts, much of this incremental risk comes from currency fluctuations. Currency hedging is one way to reduce this risk, but this approach also sacrifices the protection that foreign stocks can offer against a decline in the value of the dollar. 

A low-volatility international-stock fund, such as  iShares MSCI EAFE Minimum Volatility (EFAV), may offer a better way to reduce the risk of investing in foreign stocks. It attempts to form the least volatile portfolio from the MSCI EAFE Index, which includes stocks from developed markets in Europe, Australia, and Asia. These stocks are more likely to enjoy durable competitive advantages than the average company in the MSCI EAFE Index and tend to be more profitable. For instance, the fund's holdings generated a higher average return on invested capital (13.7%) than those in the MSCI Index (10.4%) over the trailing 12 months through December 2013. They skew toward defensive sectors including health care, telecom, consumer defensive, and utilities. But these tilts aren't too exaggerated because the fund's sector and country weights are anchored to the MSCI EAFE Index. Not surprisingly, the fund's quality holdings tend to be less sensitive to the business cycle than their peers, which helps provide a smoother ride.

The back-tested performance of this low-volatility strategy is impressive. From June 1988 through December 2013, the MSCI EAFE Minimum Volatility Index outpaced its parent index, with about 80% of the volatility (the fund was only launched in October 2011). During that span, the MSCI USA Minimum Volatility Index kept pace with the broader U.S. equity market, with a similar reduction in volatility. These results are broadly consistent with more-rigorous empirical studies on the performance of low-volatility stocks. 

While they may not continue to keep pace with the broad market going forward, there is reason to believe that low-volatility strategies, such as the one this fund pursues, will continue to offer better risk-adjusted returns than the market. Most active money managers are compensated based on their performance relative to a benchmark. However, many are not allowed to use leverage to boost returns. In order to juice their returns, these investors may tilt toward high-beta (volatile) stocks, which should, in theory, outperform their less risky counterparts. However, this collective bet on high-beta stocks pushes their prices above their fair values, leading to low risk-adjusted returns. Conversely, these managers may neglect boring low-volatility stocks, which can cause them to become undervalued relative to their risk. This bias is not isolated to professional managers. Rather, it extends to any investor who is unable or unwilling to use leverage to meet return objectives. Investors may also overpay for volatile stocks because they often offer a small chance of a large payoff, much like a lottery ticket.

Despite the structural advantages that low-volatility stocks enjoy, they carry relatively high interest-rate risk because their cash flows are less sensitive to the business cycle than the average company. That has worked to their advantage over the past few decades when interest rates were falling. However, rising interest rates could create a bigger hurdle for low-volatility stocks going forward because they will likely experience less growth to offset the negative impact of higher rates. 

The fund's geographic diversification helps reduce this risk. Just more than half of the fund's assets are invested in continental Europe and Japan, where rates will likely remain low for quite some time. The Bank of Japan's new governor, Haruhiko Kuroda, has committed to an aggressive monetary policy in order to hit a 2% inflation target by the end of 2014. As a result, Japanese interest rates will likely remain ultralow. Similarly, the European Central Bank is unlikely to raise interest rates in the near term because the eurozone is struggling with an unemployment rate above 12% and anemic growth. Even with their interest-rate sensitivity, low-volatility stocks will likely continue to be less risky than the broad market.

The Macro View
The eurozone has a long way to go to resolve structural imbalances and establish a sustainable growth trajectory. Deleveraging in the public and financial sectors has significantly weakened demand, which has intensified price competition. In order to control costs, firms have laid off workers and cut back on hiring. High unemployment contributes to the vicious cycle of weak demand as consumers cut discretionary spending. Given these challenges, it is not surprising that the fund currently has an underweighting in stocks based in the eurozone. 

However, conditions in Europe have started to stabilize. Business activity across the eurozone has expanded throughout the second half of 2013, according to Markit Purchasing Manager Index Survey data. New orders and exports helped drive this growth. This improvement in demand has helped reduce the number of job losses, though the labor market remains weak. The recovery has been uneven, with Ireland and Germany generally holding up better than Italy, France, and Spain. The United Kingdom has held up better than its neighbors on the continent. It enjoyed healthy growth in the manufacturing and services sectors throughout much of 2013, based on PMI survey data. This growth has driven an improvement in business confidence and employment. 

Japan faces similar structural challenges as Europe, including the highest level of debt to gross domestic product of any developed country, a thrifty and rapidly aging population, and persistent deflation. However, the Bank of Japan's new aggressive monetary policy could help bolster domestic demand. This policy shift has already caused the yen to depreciate sharply against the U.S. dollar. A weaker yen may make Japanese exports more competitive.

While the fund's holdings were generally better positioned to weather the tough economic climate of the past few years better than the broad market, they will likely lag as the global economy strengthens. As a result of their relative safety, the fund's holdings were trading at a slightly higher price/forward earnings multiple (16.1) than those in the broad MSCI EAFE Index (14.9) at the end of December. 

Portfolio Construction
The fund employs full replication to track the MSCI EAFE Minimum Volatility Index, which attempts to create the least volatile portfolio with stocks from the MSCI EAFE Index. This selection universe includes large- and mid-cap stocks based in developed-markets countries in Asia, Europe, and Australia. MSCI draws on the Barra Equity Model for estimates of the risk factor exposures for each security in the MSCI EAFE index and the covariances of these risk factors between securities. It then feeds this data into an optimization algorithm that produces a minimum variance portfolio, subject to several constraints. These constraints include keeping stock weights between 0.05% and 1.5% of the portfolio, sector and country weights within 5% of the EAFE Index (this limit is tighter for countries that represent less than 2.5% of the MSCI EAFE Index), and limit one-way turnover to 10%. The algorithm also applies constraints to limit tilts to other factors, such as value. This model implicitly assumes that past correlations and volatility estimates will persist in the short term, which has been a reasonable assumption in the past. The index is reconstituted semiannually. 

Fees
At 0.20%, this fund's expense ratio isn't much higher than the cheapest market-cap-weighted alternatives. Its turnover cap helps keep trading costs down, without sacrificing much style purity. BlackRock engages in securities lending. It passes 65% of the proceeds to investors, which partially offsets the fund's expenses. As a result, the fund lagged its benchmark by slightly less than the amount of its expense ratio over the past year.  

Alternatives
PowerShares S&P International Developed Low Volatility (IDLV) (0.25% expense ratio) is the closest alternative. It simply ranks international stocks by their trailing 12-month volatilities, selects the least-volatile fifth, and weights them by the inverse of their volatilities. The least volatile stocks receive the greatest weights in the portfolio. However, IDLV does not anchor its sector or country weights to a market-cap-weighted benchmark. Consequently, it may take more concentrated bets. In contrast to EFAV, this fund also includes Canadian stocks. It also rebalances more frequently (once a quarter). 

Db X-trackers MSCI EAFE Hedged Equity ETF (DBEF) (0.35% expense ratio) offers broad currency hedged exposure to large- and mid-cap developed-markets stocks. This currency hedge helps reduce volatility. However, DBEF does not specifically target stocks with low volatility. 

1) Frazzini, Andrea and Pedersen, Lasse. 2013. "Betting Against Beta." 

 

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