Defensive strategies provide a way to invest in stocks while incurring less risk than a cap-weighted index. Less risk means a smoother ride, and these types of funds should hold up better during market downturns. IShares Edge MSCI Min Vol EAFE ETF EFAV is an appealing, low-cost fund that captures these characteristics. It takes additional measures to promote diversification and limit turnover, meaning it could be used as a core holding. EFAV’s integrated approach to portfolio construction and proven ability to cut back on risk earn a Morningstar Analyst Rating of Silver.
The management team at BlackRock uses full replication to track the MSCI EAFE Minimum Volatility Index. The strategy uses an optimizer that selects and weights stocks from the MSCI EAFE Index in a way that minimizes expected volatility. This integrated approach looks for names with low levels of expected volatility, but it also considers how they behave relative to one another. Therefore, it can own volatile stocks if their low correlations are expected to reduce the portfolio’s overall volatility.
This strategy also 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 weight in the parent index. Turnover also gets capped at 10% during each semiannual rebalance to mitigate trading costs. The final portfolio holds less than one third of the stocks in its parent index. But it still diversifies stock-specific risk, with only 13% of its assets in its 10 largest names.
This fund’s big appeal is its ability to maintain exposure to stocks while taking less risk than the market. It will likely lag the MSCI EAFE Index during strong bull markets but hold up better when the market declines. This should outweigh the gains that it sacrifices during market rallies and lead to better risk-adjusted performance over the long haul.
This approach has worked well. Between February 2018 and December 2018, the MSCI EAFE Index declined by 17.9% while the fund lost about half that figure. 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 foreign large-blend 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, indicating 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 EAFE Index that have exhibited lower volatility than their peers. This often pulls the portfolio toward traditionally stable industries, like consumer staples and utilities. However, the fund limits its sector weightings to within 5% of the MSCI EAFE Index to maintain diversification and control the amount of active risk that it takes.
But the fund does more than look for stable firms in isolation. It looks for holdings that will help mitigate the volatility of the overall portfolio. So, volatile stocks that do not fit the traditional low-risk mold can find their way into the portfolio if they have sufficiently low correlations with the other holdings in the portfolio. For example, Randgold Resources is a risky mining company that has qualified as a holding because its correlation with other stocks in the portfolio was low, which damps the final portfolio’s risk.
This portfolio does take on considerable active risk. It held less than one third of the stocks in the MSCI EAFE 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. From November 2011 through May 2019, its drawdowns were 44% lower than those of the MSCI EAFE Index. Over the long haul, it should offer a smoother ride than this yardstick, 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 EAFE Index from its launch through May 2019. It performed better on a risk-adjusted basis, with a Sharpe ratio of 0.72 compared with 0.44 for the cap-weighted benchmark over this period. Its maximum drawdown was also shallower, losing 8.8% between February 2018 and December 2018 compared with 17.9% for the MSCI EAFE 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 EAFE Minimum Volatility Index. This strategy starts with all stocks in the MSCI EAFE 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 be 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 fee earns a Positive Price Pillar rating. BlackRock charges 0.20% annually for this fund, and it lands in the cheapest decile of the foreign large-blend category. The fund takes direct measures to limit its turnover, which should mitigate trading costs. It lagged its target index by 5 basis points annually over the trailing three years through May 2019--an amount less than its expenses. Securities lending revenue and conservative tax withholding assumptions embedded in the fund's target index allowed it to recover some of its fees.
Alternatives BlackRock has a suite of minimum volatility funds. IShares Edge MSCI Minimum Volatility USA ETF USMV (0.15% expense ratio) and iShares Edge MSCI Minimum Volatility Emerging Markets ETF EEMV (0.25% expense ratio) apply the same framework as EFAV to stocks from the U.S. and emerging markets, respectively. IShares Edge MSCI Minimum Volatility Global ETF ACWV (0.20% expense ratio) also applies the same process as EFAV but starts with a broader universe of global stocks. These three funds also earn Morningstar Analyst Ratings of Silver.
Invesco S&P International Developed Low Volatility ETF IDLV (0.25% expense ratio) is another foreign stock fund that attempts to reduce risk. It holds the least volatile 200 stocks from the S&P Developed ex-U.S. & South Korea LargeMid Cap Broad Market Index and weights them by the inverse of their volatility. This approach is more transparent than an optimizer, but it does not control country or sector weights, which can cause the fund to take on more country and sector-risk than EFAV. It does not take steps to mitigate turnover, which has been high.
Bronze-rated Vanguard International Dividend Appreciation ETF VIGI (0.25% expense ratio) doesn’t directly attempt to reduce volatility. Instead, it looks for companies that have maintained or increased dividend payments for seven straight years. This strict standard limits its portfolio to a select number of high-quality firms. Their willingness and capacity to continue paying dividends means they tend to be more stable than the broader foreign market. This fund selects stocks from a wider universe than EFAV by including those from emerging markets. It also weights holdings by market capitalization to promote low turnover.