This Foreign Large-Cap Fund Should Provide a Smoother Ride

The fund attempts to create the least-volatile portfolio possible with large- and mid-cap stocks listed in developed markets in Europe, Australia, and Asia under a set of constraints. These include limiting sector and country tilts relative to the MSCI EAFE Index, which improves diversification. This strategy doesn't just target the least-volatile stocks. It also takes into account each stock's exposure to common risk factors and how they interact with each other to affect the portfolio's overall volatility.

The resulting portfolio includes more than 200 names, such as Nestle, Novartis, and Roche. These firms tend to enjoy more-stable cash flows than the typical constituent in the MSCI EAFE Index. But more-volatile names can make the cut if they have low correlations with the other stocks in the portfolio and help reduce overall portfolio risk. Individual stocks do not exert significant influence on the fund's performance.

So far, the fund's approach has worked well. From November 2011 through August 2017, it exhibited 22% less volatility than its parent index. And it outpaced the benchmark by 1.6 percentage points annualized during that time. This was primarily thanks to more-favorable stock exposure within several sectors rather than differences in sector weightings.

Performance will not always be this strong. The fund will likely lag during bull markets and probably won't generate market-beating returns over the long run. But it should hold up better than most of its peers during downturns and offer better risk-adjusted returns than the MSCI EAFE Index over a full market cycle. Its holdings may be priced to offer attractive returns relative to their risk because their tendency to lag in bull markets can make them unattractive to benchmark-sensitive investors.

Fundamental View Investors can always reduce risk by allocating a greater portion of their portfolios to less-risky assets like cash or bonds. But this strategy will likely offer better returns than a market-cap-weighted stock/bond portfolio of comparable volatility, albeit with smaller diversification benefits.

Historically, less-risky stocks (as defined by volatility or market sensitivity) have offered better risk-adjusted returns than their riskier counterparts. This effect was documented in 1972 by Fischer Black, Michael Jensen, and Myron Scholes. They found that stocks with low sensitivity to market fluctuations (low betas) generated higher returns relative to their amount of market risk than stocks with high sensitivity to the market. Several other researchers found a similar pattern for stocks sorted on volatility.

Robert Novy-Marx, a professor at the University of Rochester, attributes low-volatility stocks' attractive performance from 1968 to 2013 to their low average valuations and high profitability in his paper, "Understanding Defensive Equity." He argues that investors would be better off targeting stocks with value and profitability characteristics directly because there is no guarantee that low-volatility stocks will always have these characteristics. In fact, this fund explicitly limits its value tilt.

While low valuations and high profitability likely contributed to low-volatility stocks' attractive historical performance, there is probably more to the story. Many investors care about benchmark-relative returns, which may cause them to favor riskier stocks that have higher expected returns in bull markets, reducing their expected returns relative to their risk. Similarly, neglected lower-risk stocks can become undervalued relative to their risk. This is not necessarily the same as the traditional value effect, as many of these stocks often trade at comparable or slightly higher valuations than the market. Andrea Frazzini and Lasse Pedersen, two principals from AQR, develop this argument in their paper, "Betting Against Beta."

The fund has a smaller market-cap orientation than the MSCI EAFE Index. Although smaller stocks tend to be less profitable than their larger counterparts, the fund's holdings tend to generate a similar average return on invested capital to the constituents of the MSCI EAFE Index. It also tends to invest in firms with conservative asset growth, which can translate into higher free cash flows.

Not surprisingly, the fund has greater exposure to defensive sectors, such as utilities, healthcare, and consumer defensive, than the MSCI EAFE Index. It also has greater exposure to the real estate sector and less exposure to the more-volatile energy, materials, technology, and financial-services sectors. The fund's sector constraints prevent it from loading up on the least-volatile sectors but also better diversify risk.

The portfolio currently has greater exposure to stocks listed in Japan and the United Kingdom than the MSCI EAFE Index and less exposure to stocks in the eurozone, reflecting the volatility of the region. While the fund does not explicitly control for currency risk, it does measure stock volatility and covariances based on U.S. dollar returns, which reflects the impact of currency fluctuations.

Portfolio Construction The fund earns a Positive Process Pillar rating because it uses a holistic approach to reduce volatility, targets stocks that have historically offered superior risk-adjusted performance, and applies reasonable constraints to preserve diversification and limit turnover.

It 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. It draws on the Barra Equity Model for estimates of each stock's volatility, sensitivity to risk factors, and the covariances between them. MSCI then feeds this data into an optimization algorithm that selects the constituents and weightings expected to have the lowest volatility, subject to several constraints. These constraints keep stock weightings between 0.05% and 1.5% of the portfolio, sector and country weightings within 5% of the EAFE Index (this limit is tighter for countries that represent less than 2.5% of that index), and one-way turnover limited to 10%. The algorithm also applies constraints to limit tilts to other factors, such as value. These constraints improve diversification, allowing investors to use this fund as a core holding. But they may also reduce its style purity. Additionally, the model isn't fully transparent. It implicitly assumes that past volatility and correlations will persist in the short term, a relationship that has historically held. The index is reconstituted semiannually.

Fees The fund's 0.20% expense ratio is among the lowest in the foreign large-blend Morningstar Category, supporting the Positive Price Pillar rating. In fact, it isn't much higher than the cheapest market-cap-weighted alternatives. The turnover cap helps limit trading costs. BlackRock engages in securities lending; this ancillary income partially offsets the fund's expenses. As a result, the fund lagged its benchmark by 6 basis points annualized during the trailing three years through August 2017.

Alternatives PowerShares S&P International Developed Low Volatility ETF IDLV (0.25% expense ratio) is one of the closest alternatives. 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. Consequently, the least-volatile stocks receive the greatest weightings in the portfolio. However, IDLV does not constrain its sector or country weightings, and as a result, it can make concentrated bets. In contrast to EFAV, the PowerShares fund also includes Canadian stocks.

Investors interested in applying a low-volatility strategy to a global portfolio of stocks might consider Silver-rated

Similar to ACWV, Silver-rated

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