Defensive stock funds provide a way to invest in stocks while incurring less risk than a cap-weighted index. Less risk means a smoother ride, and these strategies should hold up better during market downturns.
The fund tracks the MSCI EAFE Minimum Volatility Index. Its construction process starts with all stocks in the MSCI EAFE Index, and it uses an optimizer to select and weight stocks in a way that minimizes the portfolio's expected volatility while honoring several constraints. It limits individual stock weightings to 1.5% of the portfolio and holds country and sector weightings to 5% of the parent index weighting. These constraints promote diversification while controlling active risk but can limit the fund's style purity. It also imposes turnover limits to rein in trading costs. The final portfolio holds less than 30% of the stocks in its parent index, but it is still well-diversified.
While the fund constrains its sector weightings, there is some wiggle room, so it still makes some modest sector bets. It has had a persistent overweighting in firms from traditionally stable sectors like consumer staples and utilities, while underweighting those from more volatile sectors like technology and energy. But targeting stable firms is only part of this fund's strategy. It also accounts for the way stocks behave relative to one another. If a volatile stock has exhibited low correlation with the portfolio, then the fund may include that stock to reduce the portfolio's overall volatility.
The fund's approach has successfully achieved its goal of reducing risk. From its launch in October 2011 through June 2018, its volatility was 23% lower than the MSCI EAFE Index, allowing its risk-adjusted returns to easily beat this same bogy. Its 0.20% expense ratio is another attractive feature. This fee ranks among the lowest in the foreign large-blend Morningstar Category and provides the fund with a sustainable advantage over its more expensive competitors.
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 EFAV 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 could pull the portfolio toward traditionally stable industries, like consumer staples and utilities. While the fund tilts toward these sectors, it limits their weighting to be within 5% of the MSCI EAFE Index to maintain diversification and control the amount of active risk that it takes. This has been historically reflected in the portfolio.
But highly volatile stocks that do not fit the traditional low-risk mold can also find their way into the portfolio. The optimizer considers how stocks behave relative to one another, so it may add names if they can reduce the portfolio's overall risk. For example, Newcrest NCM is a risky mining company that qualifies as a holding because its recent correlation with other stocks in the portfolio has been low, which tempers the final portfolio's risk.
While the fund's construction process takes steps to control active risk, it held less than 30% of the stocks in the MSCI EAFE Index as of June 2018. Therefore, its performance can differ from this benchmark 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 June 2018, its drawdowns were 43% 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 23% lower than the MSCI EAFE Index from its inception through June 2018. It performed better on a risk-adjusted basis, with a Sharpe ratio of 1.01 compared with 0.58 for the cap-weighted benchmark during this period. Its maximum drawdown was also shallower, losing 7.9% between May 2015 and February 2016 compared with 18.0% for the MSCI EAFE Index. However, the fund has not yet been tested during a substantial market drawdown.
Portfolio Construction This fund uses a holistic rules-based strategy to minimize volatility. It favors defensive stocks, employs constraints to promote diversification, and should hold up better than the market during downturns. It earns a Positive Process Pillar rating.
The managers use full replication to track the MSCI EAFE Minimum Volatility Index. MSCI employs the barra equity model to estimate the volatility of all stocks in the MSCI EAFE Index, as well as their expected future relationship with each other based on factor exposures. This model overweights more-recent data, which should be more predictive of future behavior than older numbers. MSCI feeds this information into an optimizer that attempts to construct the least-volatile portfolio while enforcing several constraints. The portfolio keeps country and sector exposures within 5% of its parent index and holds individual stock weightings between 0.05% and 1.50% of the portfolio. It also controls for its exposure to other styles, like value and momentum. Limiting the portfolio in these ways promotes diversification and controls the index's active risk. The methodology keeps transaction costs down by limiting one-way turnover to 10% at each semiannual rebalance in May and November.
Fees BlackRock charges a 0.20% expense ratio for this fund. It lands in the cheapest decile of the foreign large-blend category and earns a Positive Price Pillar rating. The methodology employed on this fund takes direct measures to limit its turnover, which should translate into lower trading costs. The fund's total returns lagged its target index by 5 basis points annually over the trailing three years through June 2018. Securities-lending revenue and conservative foreign tax assumptions helped the fund recover some of its expenses.
BlackRock has a suite of minimum-volatility funds.
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 LargeMidCap 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 weightings, 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.