An Emerging-Markets Fund That Takes Less Risk

Stocks listed in emerging markets tend to be riskier than those focused on developed markets, and a number of these risks are prevalent in low-cost index-tracking funds from Vanguard, iShares, and Schwab. Country biases, volatile currency movements, and state-owned enterprises are among the risks investors need to be mindful of in developing nations. Broad diversification is a starting point, but further steps can be taken to reduce risk and volatility. A minimum volatility strategy, like

IShares Edge MSCI Minimum Volatility offers a well-diversified and low-cost portfolio that should provide a smoother ride and better risk/reward profile than most of its peers in the diversified emerging-markets Morningstar Category. It earns a Morningstar Analyst Rating of Silver.

The fund uses an optimizer to construct the least-volatile portfolio possible using constituents of the MSCI Emerging Markets Index under a set of constraints. The optimizer takes into account each stock’s volatility and how they interact with each other to affect the portfolio’s volatility. It uses this information to select and weight stocks from the parent index. However, the fund limits sector and country tilts relative to the MSCI Emerging Markets Index, exposure to individual names, and turnover, which reduces transaction costs. These constraints reduce the fund's style purity, but they also allow investors to use this as a core holding.

The resulting portfolio is well diversified across 250 stocks, and its top-10 holdings account for only 15% of assets. The corresponding figure for the average fund in the category is nearly 30%. The fund’s top holdings include companies with more-stable fundamentals than the typical constituent of the MSCI Emerging Markets Index, such as

From November 2011 through August 2017, the fund outpaced the MSCI Emerging Markets Index by 0.4 percentage points annualized, with 23% lower volatility. This outperformance can be partially attributed to differences in sector exposures, specifically, underweightings in basic materials and energy and an overweighting in healthcare. Less exposure to countries such as Brazil and Russia also helped performance. The fund won’t always come out ahead: Investors should expect it to lag in strong market rallies.

Fundamental View Riskier stocks should compensate investors with higher expected returns over the long run. However, in 1972, Fischer Black, Michael Jensen, and Myron Scholes provided evidence that the relationship between stocks' exposure to market risk (as measured by beta) and their subsequent returns wasn't as strong as expected. Stocks with the lowest market risk offered the best risk-adjusted returns and those with the highest risk offered the worst risk/reward profiles. Subsequent follow-up studies were able to replicate the findings, and others also showed the effect held when portfolios were constructed based on volatility.

A couple of explanations for this low-volatility phenomenon have been proposed based on the behavioral tendencies of investors. Nicholas Barberis and Ming Huang in their paper, “Stocks as Lotteries: The Implications of Probability Weighting for Security Prices,” argue investors are willing to pay very high prices for stocks that offer a potentially large payoff because they underestimate the risk. As a result of the high prices, these stocks earn lower returns, on average.

Andrea Frazzini and Lasse Pedersen in their paper, “Betting Against Beta,” propose another theory. They argue that investors will favor riskier stocks with higher expected returns in bull markets attempting to achieve superior benchmark-relative performance. This activity drives up the price of these risky stocks, thereby reducing their expected returns relative to their risk. Simultaneously, the lower-risk stocks become undervalued relative to their risk. While the fund leans toward these stocks, it does not offer pure exposure to the low-volatility effect documented in the literature.

Unsurprisingly, this fund’s sector allocation leans heavily toward defensive sectors, such as healthcare, utilities, and consumer defensive, compared with the category average. Stocks in these three sectors account for 28% of the fund’s portfolio compared with the less-than-16% category average. This helps minimize volatility associated with economic risk. Similarly, this fund has a significantly lower allocation to sectors strongly affected by economic shifts, such as basic materials, consumer cyclical, financial services, and real estate. These sectors combined account for 33% of the fund’s portfolio, which is much less than the 46% category average.

This fund is also better diversified across emerging-markets countries compared with its MSCI Emerging Markets Index parent. This fund’s allocation to Chinese stocks is comparable to the 20% category average, whereas most market-cap-weighted emerging-markets index funds have a 30% allocation to China, which creates meaningful single-country risk. Relative to the category average, the fund also has less exposure to many commodities-driven economies such as Brazil and Russia, which tend to be very cyclical.

The fund will likely hold up better than most of its peers in weak market environments, as emerging markets have experienced in the past few years, and lag during market rallies. Over a full market cycle, it should offer a better risk/reward trade-off than most of its peers, though it may not offer higher absolute returns.

Portfolio Construction The fund employs full replication to track the MSCI Emerging Markets Minimum Volatility Index and applies several constraints to limit turnover and improve diversification. Therefore, it earns a Positive Process Pillar Rating.

The MSCI Emerging Markets Minimum Volatility Index aims to create the least-volatile portfolio with constituents from the MSCI Emerging Markets Index. It uses the Barra Equity Model to estimate each stock’s volatility, sensitivity to risk factors, and 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 MSCI Emerging Markets Index; and one-way turnover limited to 10%. These constraints improve diversification but may also reduce its style purity. Additionally, the model isn’t fully transparent. The index is reconstituted semiannually in May and November.

Fees BlackRock charges a low 0.25% expense ratio for this fund, making it one of the cheapest defensive emerging-markets equity funds available and supporting a Positive Price Pillar rating. During the trailing three years through August 2017, the fund has lagged its benchmark by 20 basis points annualized. This is partially because of securities-lending revenue, which helped offset the fund's expenses.

Alternatives PowerShares S&P Emerging Markets Low Volatility ETF EELV (0.29% expense ratio) takes a very different approach to reduce volatility: It simply targets 200 stocks from its parent index (S&P BMI Emerging Plus Large MidCap Index) that have exhibited the lowest volatility during the past year and weights them by the inverse of their realized volatility. There are no constraints on turnover, or sector or country weightings, which can lead to some concentrated bets. While this is a less well-diversified alternative, it should offer cleaner exposure to the low-volatility effect documented in the academic literature. This fund is rebalanced quarterly.

Gold-rated