A Low-Risk Approach to the Global Market

Global-stock funds hold a certain appeal for investors who want to reduce their portfolio's complexity while maintaining diversification across multiple global regions. Combining a broad portfolio with a minimum-volatility strategy should help reduce risk and smooth out returns relative to a market-cap-weighted benchmark. Throw in a low expense ratio and the result is a compelling, all-in-one fund for long-term investors. IShares Edge MSCI Minimum Volatility Global ETF's (ACWV) proven ability to cut back on risk and provide better risk-adjusted performance than a market-cap-weighted index earns a Morningstar Analyst Rating of Silver.

The fund tracks the MSCI ACWI Minimum Volatility Index. It uses an optimizer that selects and weights stocks from the MSCI All Country World Index in a way that minimizes expected volatility. It looks for stocks with low levels of expected volatility, but it also considers how stocks behave relative to one another. Therefore, it can overweight volatile stocks if their low correlations are expected to reduce the portfolio's overall volatility.

This strategy uses constraints to promote diversification. It limits individual stocks to 1.5% of the portfolio while country and sector weights are held within 5% of their weights in the parent index. Turnover also gets capped at 10% during each semiannual rebalance to mitigate trading costs. The portfolio holds less than 20% of the stocks in its parent index. But it still diversifies stock-specific risk with only 10% of its assets in its 10 largest names.

Low-risk strategies are attractive because they can provide a smoother ride than a market index. It should lag the MSCI ACWI during rallies but hold up better when the market declines. This should outweigh the upside it sacrifices in bull markets and lead to better risk-adjusted performance over the long haul. Behavioral biases may create mispricing among defensive stocks that can help performance. But even without mispricing, the portfolio's focus on stocks with low correlations should reduce risk without necessarily hurting returns.

This approach has worked well. Between October 2018 and December 2018, the MSCI ACWI declined by 12.8%, while the fund lost about half that figure. And it was 27% less volatile than the benchmark from its launch in October 2011 through May 2019. Less risk pushed its risk-adjusted returns to the top of the world large-stock Morningstar Category over that stretch.

Fundamental View
Minimum-volatility strategies can be an effective way to maintain exposure to stocks while mitigating risk. Defensive stocks tend to lag during market rallies, but they tend to hold up better than most during downturns. While minimum-volatility strategies, such as this one, may not offer higher returns than the market, historically they have offered better risk-adjusted performance. The reduction in risk should outweigh the impact of potentially lower returns.

Investor behavior is one reason that a low-volatility strategy can deliver superior risk-adjusted performance. Investors may chase after risky stocks with the expectation of receiving higher total returns. In the process, they simultaneously abandon less risky stocks and cause them to become undervalued, positioning them to deliver higher rates of return than their volatility would suggest.

This fund achieves its low risk profile in two ways. First, it targets stocks in the MSCI ACWI that have exhibited lower volatility than their peers. This could pull the portfolio toward traditionally stable industries, like consumer staples and utilities. While the fund tilts toward these sectors, it limits their weight to be within 5% of the MSCI ACWI's to maintain diversification and control the amount of active risk that it takes. This has been historically reflected in the portfolio.

Second, the fund's process considers how stocks behave relative to one another, so it may add volatile names if they can reduce its overall risk. For example, Barrick Gold (GOLD) is a risky mining company that has qualified as a holding because its correlation with other stocks in the portfolio had been low.

While the fund's construction process takes steps to control active risk, it held less than 20% of the stocks in the MSCI ACWI as of May 2019. Therefore, its performance can differ from the global stock market, sometimes for years. More specifically, this strategy will likely lag cap-weighted strategies when the market posts strong returns, but it should fare better when the market goes through a drawdown. From November 2011 through May 2019, it captured 74% of the MSCI ACWI's upside but only 45% of its downside. Over the long haul, it should offer a smoother ride than this benchmark.

This fund was launched in October 2011, and so far, it has lived up to its billing. Its volatility was 27% lower than the MSCI ACWI from November 2011 through May 2019 while its total return was comparable. This helped it perform better on a risk-adjusted basis, with a Sharpe ratio of 1.12 compared with 0.72 for the cap-weighted benchmark. Its maximum drawdown was also shallower, losing 7.5% between May 2015 and February 2016 compared with 13.5% for the index.

Portfolio Construction
This fund earns a Positive Process Pillar rating because its holistic approach to portfolio construction effectively cuts back on risk which improves risk-adjusted performance relative to a market-cap-weighted benchmark.

The managers use full replication to track the MSCI ACWI Minimum Volatility Index. This strategy starts with all stocks in the MSCI ACWI. It uses the Barra Equity Model to estimate the stocks' volatility and their expected future relationship with each other based on factor exposures. This information is fed into an optimizer that attempts to construct the least volatile portfolio while enforcing several constraints. It holds country and sector weights within 5% of their weight in the parent index, while the weight of individual stocks is held to between 0.05% and 1.5% of the portfolio. The model also overweights more-recent data, which should be more predictive of future behavior than older, stale numbers. The strategy limits one-way turnover to 10% at each rebalance, which promotes lower trading costs. The index reconstitutes semiannually in May and November.

Fees
This fund's low expense ratio earns a Positive Price Pillar rating. BlackRock charges a 0.20% annual fee, and it lands in the cheapest decile of the world large-stock category. The fund takes direct measures to limit its turnover, which should mitigate trading costs. Its total return beat its target index by 23 basis points annually over the trailing three years through May 2019. Securities-lending revenue and conservative tax withholding assumptions embedded in the fund's target index enabled it to make up for its fee. While this can be an advantage, investors should not expect this activity to continue producing index-beating returns.

Alternatives
Silver-rated Vanguard Global Minimum Volatility (VMNVX) (0.15% expense ratio) follows a similar investment strategy. Its construction process also uses an optimizer to select and weight stocks based on their historic volatility as well as their relative behavior. Like ACWV, the managers limit sector and country exposure to within 5% of the global market, but they also hedge away the fund's foreign-exchange risk, which should further reduce its long-term volatility.

BlackRock has a lineup of minimum-volatility funds. IShares Edge MSCI Minimum Volatility USA ETF (USMV) (0.15% expense ratio), iShares Edge MSCI Minimum Volatility EAFE ETF (EFAV) (0.20% expense ratio), and iShares Edge MSCI Minimum Volatility Emerging Markets (EEMV) (0.25% expense ratio) follow the same process as ACWV but target stocks from distinct global regions. These three funds also earn Analyst Ratings of Silver.

Invesco S&P 500 Low Volatility ETF (SPLV) (0.25% expense ratio) sticks to U.S. large caps and has a more concentrated portfolio. Each quarter it ranks stocks in the S&P 500 by their volatility over the prior year, and it holds the 100 least volatile. It then weights these stocks by the inverse of their volatility, so the least volatile stocks are the most heavily weighted. While its process is more transparent than ACWV's, it does not control its sector weights, so its industry bets can be bigger than ACWV's. It also does not take measures to limit turnover, which ran high between 2013 and 2017. It has a Bronze rating.