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ETF Specialist

A Less Volatile Way to Invest in Emerging Markets

A smoother ride is possible.

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Emerging-markets stocks carry more risk than their developed-markets counterparts. Political instability, poor corporate governance, and immature regulatory and legal systems can lead to volatility that may be difficult to stomach. A low-volatility strategy like iShares Edge MSCI Min Vol Emerging Markets ETF (EEMV) can take some of the edge off and should provide solid risk-adjusted performance over the long run. Its integrated approach to reducing volatility, well-diversified portfolio, and low fee earn the fund a Morningstar Analyst Rating of Silver.

The fund tracks the MSCI Emerging Markets Minimum Volatility Index. It uses an optimizer to select and weight stocks from the MSCI Emerging Markets Index in a way that minimizes expected volatility. This algorithm looks for companies with relatively low expected volatility while also considering 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.

The optimizer is held to several constraints that promote diversification. Individual stocks get capped at 1.5% of the portfolio, while country and sector weights are held within 5% of their weight in the parent index. This strategy also limits turnover to 10% at each semiannual rebalance to help rein in trading costs.

Low-risk strategies are attractive because they can provide a smoother ride than a market index. It should lag the MSCI Emerging Markets Index 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. The portfolio's focus on stocks with low correlations also contributes to reducing risk without necessarily hurting returns.

This approach has worked well. Between February 2018 and October 2018, the MSCI Emerging Markets Index declined by 22.2% while the fund lost about 13.5%. And it was 24% 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 diversified emerging-markets Morningstar Category over that stretch.

Fundamental View
Minimum-volatility strategies can be an effective way to maintain exposure to stocks while mitigating risk. Cutting back on risk could lead to lower rates of return than a cap-weighted index. But over long investment horizons, funds like this one have outperformed their market-cap-weighted counterparts on a risk-adjusted basis. This suggests that the reduction in risk outweighs 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 Emerging Markets Index that have lower expected 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 Emerging Markets Index to maintain diversification and control the amount of active risk that it takes.

Volatile stocks that do not fit the traditional low-risk mold can also find their way into the portfolio because the optimizer considers how stocks behave relative to one another. So, it may add risky names if they can reduce the portfolio's overall risk. For example, Anglogold Ashanti (AU) is a risky South African mining company that qualified as a holding because its correlation with other stocks in the portfolio had been low, which damps the final portfolio's risk.

While the fund's construction process takes steps to control active risk, it held less than one third of the stocks in the MSCI Emerging Markets Index as of May 2019. Therefore, its performance can differ from this benchmark, sometimes for years. More specifically, this strategy will likely lag the cap-weighted index when the market posts strong returns, but it should fare better when the market goes through a downturn. Over the long haul, it should offer a smoother ride than the MSCI Emerging Markets Index, which could help investors stick with this strategy.

This fund was launched in October 2011, and so far it has lived up to its billing. Its volatility was 24% lower than the MSCI Emerging Markets Index from its launch through May 2019. Its maximum drawdown was also shallower, losing 17.8% between September 2014 and May 2016 compared with 23.0% for the MSCI Emerging Markets Index.

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

The managers use full replication to track the MSCI Emerging Markets Minimum Volatility Index. This strategy starts with all stocks in the MSCI Emerging Markets Index. It uses the Barra Equity Model to estimate the volatility of each stock 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 to within 5% of their weight in the parent index, while the weight of individual stocks is held to between 0.05% and 1.50% 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 fee earns a Positive Price Pillar rating. BlackRock charges 0.25% annually for this fund, and it lands in the cheapest decile of the diversified emerging-markets category. The fund takes direct measures to limit its turnover, which should mitigate trading costs. It lagged its target index by 22 basis points annually over the trailing five years through May 2019--an amount comparable to its expense ratio.

Alternatives
BlackRock has several minimum-volatility funds that apply the same strategy to build low-risk stock portfolios from various global regions. IShares Edge MSCI Min Vol USA ETF (USMV) (0.15% expense ratio) and iShares Edge MSCI Min Vol EAFE ETF (EFAV) (0.20% expense ratio) focus on stocks from the United States and overseas developed markets, respectively. IShares Edge MSCI Min Vol Global ETF (ACWV) (0.20% expense ratio) is a broader fund that holds global stocks from all major regions. These three funds also earn Analyst Ratings of Silver.

Invesco S&P Emerging Markets Low Volatility ETF (EELV) (0.29% expense ratio) uses a different strategy to reduce volatility. It sorts stocks from the S&P Emerging BMI Plus LargeMid Cap Index by their volatility over the prior year and holds the 200 least volatile. It then weights these stocks by the inverse of their volatility, so the least risky names are the most heavily weighted. Unlike EEMV, this strategy does not control its sector or country weights. Therefore, it can take on more industry- or geographic-specific risk. It does not place any restrictions on turnover, which has been high.

Bronze-rated Vanguard FTSE Emerging Markets ETF (VWO) (0.12% expense ratio) is one of the broadest and cheapest funds in the diversified emerging-markets category. It covers stocks of all sizes and includes those listed in South Korea. This portfolio weights its holdings by market capitalization--an approach that captures the market's collective wisdom of each stock's relative value. It should perform better than EEMV during bull markets but also suffer deeper declines during downturns.

Daniel Sotiroff does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.