A Low-Volatility ETF for Emerging Markets

This strategy has had a good track record. During the trailing 15- and 10-year periods through March 2016, this fund's underlying index generated about 400 basis points of annualized outperformance versus the cap-weighted MSCI Emerging Markets Index, with significantly lower volatility. The minimum-volatility index’s standard deviation of returns during the past decade was 19%, while the corresponding figure for the cap-weighted index was 24%. The minimum-volatility index has also seen less dramatic drawdowns. Following the 2008 financial crisis, while the MSCI Emerging Markets Index had a maximum drawdown of negative 59%, this fund's index fell by 49% during the same period. Likewise, in 2011, when this fund's index fell 6%, the cap-weighted index fell 18%. These relatively muted drawdowns explain much of the strategy's outperformance versus its cap-weighted parent index during the past five years. Investors should note, however, that while this fund will generally suffer less during bear markets, it will also tend to lag during bull markets.

Although EEMV is a minimum-volatility strategy, it is still risky. Investors in emerging markets are negatively affected when the U.S. dollar strengthens against emerging-markets currencies. EEMV, like most funds that invest in international equities, does not hedge its foreign-currency exposure. During the past three years, declines in emerging-markets currencies, particularly the Brazilian real and the South African dollar, have been a drag on this fund's performance.

Fundamental View Historically, low-volatility stocks have outperformed high-volatility stocks over the long term. This "volatility anomaly" was first discovered in 1968 by financial economist Robert Haugen, who theorized that behavioral factors were behind this phenomenon. More specifically, investors tend to chase risky stocks, expecting these companies to deliver higher returns. This drives up the stock prices of riskier names, which ultimately results in weaker future returns relative to less-volatile names.

Thanks in part to the heterogeneity of the emerging-markets equity asset class, low-volatility strategies in emerging markets have historically resulted in a greater reduction in portfolio volatility relative to a cap-weighted index than in U.S. equities. In other words, there is more diversity (lower correlations) among emerging-markets equities, which allows for greater reduction in price fluctuations in an emerging-markets low-volatility portfolio.

This fund’s index employs constraints to limit turnover and reduce exposure to less-liquid securities. Given that transaction costs tend to be higher in emerging markets, a low-volatility index without liquidity screens can be costly to replicate. The index also has country and sector caps; otherwise, this fund could see significant sector and/or country tilts. Over time, this fund’s country and sector weightings can shift, but these changes tend to be gradual. Overall, we think this fund's index has incorporated appropriate screens to ensure its investability.

On a fundamental level, the tailwinds from a decade of strong gross domestic product growth and stellar equity market performance in emerging markets have faded. China is undergoing a transition from an investment-driven growth model to one more oriented toward consumer spending, and it is likely to face some growing pains in the medium term. Foreign fund flows have grown more volatile and have helped expose which countries have relatively weaker fundamentals, resulting in higher currency and local stock market volatility. Almost all emerging-markets countries appear to be settling into a period of slower GDP growth in the near and medium term, but there are notable differences. By region, Asia appears to be a relative bright spot. Growth in 2016 is estimated at around 6%, as emerging Asia benefits from cheaper commodity imports and still-accommodative financial conditions. In contrast, Latin America saw its GDP contract in 2015 owing to weak commodity prices, and economies remain weak in 2016.

In the years leading up to the 2008 financial crisis, almost all of the individual emerging-markets countries exhibited very strong stock market performance. In these types of market environments, a minimum-volatility strategy (such as this fund) tends to underperform a market-cap-weighted strategy. On the other hand, when individual emerging markets exhibit very disparate returns, a minimum-volatility strategy tends to outperform a market-cap-weighted strategy.

Portfolio Construction EEMV employs full replication to track the MSCI Emerging Markets Minimum Volatility Index, which attempts to create a minimum-variance (or lowest-volatility) portfolio of 250 holdings selected from the MSCI Emerging Markets Index using an estimated security covariance matrix (the Barra Global Equity Model) and a number of constraints to limit turnover, ensure investability, and maintain sector and country diversification. On average, the fund's turnover has been about 20% a year. The index's methodology is something of a black box, as data are not available regarding the estimated risk inputs used for the covariance matrix. The portfolio is rebalanced twice a year in May and November. EEMV's portfolio represents about 40% of the roster of constituents of its parent index. That said, during the past decade, this minimum-volatility index has had a high correlation of 0.98 to its parent index. This index was launched in November 2009, so data prior to the initial calculation date reflect hypothetical historical performance.

Fees This fund charges an annual expense ratio of 0.25%, composed of a management fee of 0.67% and a fee waiver of 0.42%. According to iShares, the fee waiver may be reduced or discontinued at any time without notice. During the past three years, this fund's NAV performance has trailed that of its benchmark index by 11 basis points annualized, which is very close to its expense ratio. The goal of an index fund is to provide the returns of the index, less fees, so overall, the fund has done a reasonable job tracking its index.

Alternatives Another low-volatility option is PowerShares S&P Emerging Markets Low Volatility EELV (expense ratio 0.29%). EELV holds a portfolio of 200 stocks from its parent index (S&P BMI Emerging Plus Large MidCap Index) that have exhibited the lowest volatility during the past year. Holdings are weighted by the inverse of their realized volatility and rebalanced quarterly. This methodology is different from that employed by EEMV; as a result, the two funds tend to have fairly different portfolios. During the past three years, the iShares fund has had significantly better risk-adjusted performance relative to the PowerShares fund.

Those interested in using a low-volatility strategy for other areas of their portfolio can check out iShares' family of minimum-volatility ETFs. All of these funds track an MSCI index.

Investors can also consider actively managed funds. A list of Morningstar Medalists within our diversified emerging-markets Morningstar Category can be found here.

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