Global Diversification With a Smoother Ride

Historically, this fund's correlation to the S&P 500 has generally been lower than the correlation between the average world-stock fund and the S&P 500 and has been similar to the correlation between the average foreign large-blend fund and the S&P 500. So even though this fund has a 54% weighting in U.S. equities, it does have the potential to provide better diversification (relative to the average world-stock fund) for an investor with a large exposure to U.S. equities.

This strategy has had a good track record, as measured by the back-tested performance of this fund's benchmark index--the index's live performance commenced in November 2009. Over the trailing 15 and 10 years through May 31, 2015, this fund's underlying index generated 400 and 200 basis points, respectively, of annual outperformance versus the cap-weighted MSCI ACWI. The risk-adjusted returns were also relatively strong, with 15-year Sortino ratios of 0.94 for the minimum-volatility index and 0.34 for the cap-weighted index. However, low-volatility strategies can underperform for long periods of time and tend to lag in bull markets. This fund is suitable for use as a core holding for long-term investors.

Typically, global-equity funds are more volatile than U.S. equity funds, as the former have exposure to both international equities and the associated foreign-currency fluctuations. But because global equities are a heterogeneous asset class, there is greater diversity (as evidenced by lower correlations) among its constituents, which allows for greater reduction in overall volatility in a fund that employs a minimum-variance strategy such as ACWV. In fact, the trailing five-year standard deviation of returns for this fund's index of 8% was significantly lower than its corresponding cap-weighted index's 14%. ACWX's index was also less volatile than the S&P 500's 12% during that same span. Part of this is due to the benchmark's relatively lower drawdowns during bear markets. In 2008, when the MSCI ACWI fell 42% and the S&P 500 fell 37%, this fund's benchmark index declined 25%.

This fund does not hedge its currency exposure, so its returns reflect both asset-price changes and translation effects as the value of this fund's holdings are converted into U.S. dollars. In the 10-year period through December 2012, a rising euro, followed by a rising yen (against the U.S. dollar), helped boost the performance of this fund. However, more recently, the rising dollar has hurt the 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 Bob 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 stock prices of riskier names, which ultimately results in weaker future returns, relative to less-volatile names.

Generally, this fund had been heavy in less-volatile sectors including consumer staples, health care, telecoms, and utilities and light in cyclical sectors including financials, technology, energy, and materials relative to its parent index (MSCI ACWI). In 2013, the fund's greater exposure to less-volatile names in the United States and Japan weighed on its performance (relative to the MSCI ACWI), as higher-beta names outperformed in those markets. However, in 2014, the fund's underweighting in the energy sector boosted this fund's performance (relative to MSCI ACWI). At this time, dividend-oriented sectors such as consumer staples and utilities have been bid up in the recent low-rate environment, and sectors such as materials and energy are trading at low valuations. This fund's tilt toward more-expensive sectors and tilt away from cheaper sectors may weigh on future performance.

About 50% of this fund's assets are invested in U.S. equities. Currently, the U.S. economy appears to be on stable footing. However, now that the U.S. Federal Reserve's quantitative-easing program has ended, there is uncertainty on how monetary policy will be managed and how it might ultimately affect asset prices--especially considering that valuations across most major asset classes appear to be somewhat stretched.

This fund's second-largest country allocation is Japan, at 13%. After two "lost decades," Japan's equity markets responded very enthusiastically to Prime Minister Shinzo Abe's programs to jump-start the Japanese economy. At the start of 2013, Japan's Central Bank unleashed an aggressive monetary easing program. This move provided the foundation for improving macroeconomic fundamentals and corporate earnings growth. Japanese equities may also benefit as Japan's $1.2 trillion public pension raises allocations in domestic equities and away from low-yielding government bonds. However, any sustainable economic growth in Japan will require structural reforms to address Japan's inefficient labor market and protected private sector. These issues have long been on lawmakers' agendas, and there has been little progress or improvement on these fronts during the past two decades because of strong, entrenched interests.

European equities comprise 10% of this fund's portfolio. Many European large caps are high-quality, multinational corporations that have benefited from improving productivity, cheap financing, and exposure to faster-growing emerging markets during the past few years. Most of these firms are in good financial shape. This fund's largest European country allocations are Switzerland and the United Kingdom, and it has an underweighting (relative to the cap-weighted benchmark) in eurozone countries such as France and Germany.

Portfolio Construction This fund employs full replication to track the MSCI ACWI Minimum Volatility Index, which attempts to create a minimum-variance (or lowest-volatility) portfolio of 350 holdings selected from its parent index, MSCI All Country World Index. It does this 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. This index methodology is somewhat of a black box, as data are not available regarding the estimated risk inputs used for the covariance matrix. The index (and fund) is rebalanced twice a year in May and November. Over the past 12 months, this index's turnover was 21%. Since the fund's inception in 2011, it has not made any capital gains distributions. ACWV's portfolio represents about 20% of its parent index, which includes about 2,400 securities. During the past decade, this minimum-volatility index had a correlation of 0.92 to its parent index. But during the past three years, this correlation was lower, at 0.76. 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 0.20%, which is composed of a management fee of 0.34% and a fee waiver of 0.14%. According to iShares, the fee waiver will remain in effect through Dec. 31, 2015, but afterward may be reduced or discontinued at any time without notice. During the past three years, the fund outperformed its benchmark by 27 basis points annualized. This is partly due to the fact that the fund's benchmark incorporates aggressive foreign tax withholding assumptions. In practice, the fund has had lower foreign tax withholding relative to the estimates incorporated in its benchmark. Dividends are paid out quarterly, and, in 2014 and 2013, 95% and 86% of this fund's dividends were classified as qualified by the Internal Revenue Service, respectively (dividends from companies in certain countries are not considered qualified). Investors should note that some of the dividends paid by stocks in the fund are subject to foreign tax withholding. Investors can claim their portion of the withheld taxes as a tax credit but only if they hold this fund in a taxable account.

Alternatives One similar option is Vanguard Global Minimum Volatility VMNVX. Similar to the iShares fund, this Vanguard fund employs quant models to construct a low-volatility portfolio. Key differences are: The Vanguard fund hedges out foreign-currency exposure and has a mid-cap tilt, whereas the iShares fund does not hedge out foreign-currency exposure and has a large-cap tilt. This Vanguard fund is relatively new; its inception was in December 2013. The Admiral share class carries an annual expense ratio of 0.20%.

IShares has a suite of low-volatility strategies that cover the different segments of the global equity universe. These exchange-traded funds include

A solid core allocation option is

For a list of Morningstar Medalists in the world-stock Morningstar Category, please click here.

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