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This Global Stock Fund Takes Steps to Reduce Risk

This is a compelling defensive equity strategy.

Securities In This Article
Invesco S&P Intl Dev Low Vol ETF
iShares MSCI Global Min Vol Factor ETF
Vanguard Global Minimum Volatility Admr
iShares MSCI Emerg Mkts Min Vol Fctr ETF
Invesco S&P 500® Low Volatility ETF

Global stock funds hold a certain appeal for investors who want to reduce their portfolio’s complexity while staying diversified across the world. Combining a broad portfolio with a minimum-volatility strategy should help reduce risk and smooth out returns relative to a cap-weighted benchmark. Throw in a low expense ratio and the result is a compelling, all-in-one fund for long-term investors.

The fund attempts to construct the least-volatile portfolio possible from the large- and mid-cap stocks in the MSCI ACWI Index, which covers the United States, foreign developed, and emerging markets, under a set of constraints. These include limiting the fund’s sector and country tilts relative to its parent index to improve diversification and limit unintentional bets. This strategy doesn’t just target the least-volatile stocks. It also takes into account how stocks interact with each other to affect the portfolio's overall volatility. The fund’s global reach creates better diversification opportunities than a narrower minimum-variance strategy, which should facilitate a slightly greater reduction in volatility relative to its parent index.

The resulting portfolio includes 350 names, such as

So far the fund's approach has worked well. From November 2011 through August 2017, it exhibited 24% less volatility than its parent index. It also outpaced the benchmark by 0.76 percentage points annualized during that time. Performance will not always be this strong. The fund will likely lag during bull markets and probably won’t generate market-beating returns over the long run. But it should hold up better than most of its peers during downturns and offer better risk-adjusted returns than the MSCI ACWI Index over a full market cycle. Its holdings may be priced to offer attractive returns relative to their risk because their tendency to lag in bull markets can make them unattractive to benchmark-sensitive investors.

Fundamental View Investors can always reduce risk by allocating a greater portion of their portfolios to less-risky assets like cash or bonds. But this strategy will likely offer better returns than a market-cap-weighted stock/bond portfolio of comparable volatility, albeit with smaller diversification benefits.

Historically, less-risky stocks (defined by volatility or market sensitivity) have offered better risk-adjusted returns than their riskier counterparts. This effect was documented in 1972 by Fischer Black, Michael Jensen, and Myron Scholes. They found that stocks with low sensitivity to market fluctuations (low betas) generated higher returns relative to their amount of market risk than stocks with high sensitivity to the market. Several other researchers found a similar pattern for stocks sorted on volatility.

Robert Novy-Marx, a professor at the University of Rochester, attributes low-volatility stocks' attractive performance from 1968 to 2013 to their low average valuations and high profitability in his paper, "Understanding Defensive Equity." He argues that investors would be better off targeting stocks with value and profitability characteristics directly because there is no guarantee that low-volatility stocks will always have these characteristics. In fact, this fund explicitly limits its value tilt.

While low valuations and high profitability likely contributed to low-volatility stocks' attractive historical performance, there is probably more to the story. Many investors care about benchmark-relative returns, which may cause them to favor riskier stocks that have higher expected returns in bull markets, reducing their expected returns relative to their risk. Similarly, neglected lower-risk stocks can become undervalued relative to their risk. This is not necessarily the same as the traditional value effect, as many of these stocks often trade at comparable or slightly higher valuations than the market. Andrea Frazzini and Lasse Pedersen, two principals from AQR, develop this argument in their paper, "Betting Against Beta."

The fund has a smaller market-cap orientation than the MSCI ACWI Index. Although smaller stocks tend to be less profitable than their larger counterparts, the fund’s holdings tend to generate similar average returns on invested capital to the constituents of this benchmark. Not surprisingly, the fund has greater exposure to defensive sectors, such as utilities, healthcare, telecom, and consumer defensive, than the MSCI ACWI Index. It also has greater exposure to the real estate sector and less exposure to the more-volatile energy, technology, consumer cyclical, and financial services sectors. The fund's sector constraints prevent it from loading up on the least-volatile sectors, but they also better diversify risk.

U.S.-listed stocks currently represent about 56% of the portfolio, slightly more than their 52% allocation in the MSCI ACWI Index. This isn’t surprising because U.S. stocks tend to be less volatile than their foreign counterparts. They have less exposure to currency risk, and the fund measures stock volatility and covariances with U.S. dollar returns. The portfolio also has greater exposure to stocks listed in Japan than its parent index and less exposure to European stocks.

Portfolio Construction The fund earns a Positive Process Pillar rating because it uses a holistic approach to reduce volatility, targets stocks that have historically offered superior risk-adjusted performance, and applies reasonable constraints to preserve diversification and limit turnover. The managers employ full replication to track the MSCI ACWI Minimum Volatility Index, which attempts to create the least-volatile portfolio with stocks from the MSCI ACWI Index. It draws on the Barra Equity Model for estimates of each stock's volatility, sensitivity to risk factors, and the 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 ACWI Index (this limit is tighter for countries that represent less than 2.5% of that index), and one-way turnover limited to 10%. The algorithm also applies constraints to limit tilts to other factors, such as value. These constraints improve diversification, allowing investors to use this fund as a core holding. But they may also reduce its style purity. Additionally, the model isn't fully transparent. It implicitly assumes that past volatility and correlations will persist in the short term, a relationship that has historically held. The index is reconstituted semiannually.

Fees The fund charges a low 0.20% expense ratio, which isn't much higher than the cheapest market-cap-weighted index funds in the category. Therefore, it earns a Positive Price Pillar rating. Over the trailing three years through September 2016, the fund outpaced its benchmark by 23 basis points annualized. This is partly because the fund has had lower foreign tax withholding than the estimates incorporated in its benchmark. The managers generate ancillary income for the fund through securities lending, which partially offsets its expenses.


BlackRock offers several other minimum-variance funds that focus on different regions, including

PowerShares also offers a suite of low-volatility funds, such as

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About the Author

Daniel Sotiroff

Senior Analyst
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Daniel Sotiroff is a senior manager research analyst for Morningstar Research Services LLC, a wholly owned subsidiary of Morningstar, Inc. He covers passive strategies.

Before joining Morningstar in 2017, Sotiroff was as a design engineer at Caterpillar, where he worked on front-end loaders for heavy construction and mining applications.

Sotiroff holds a bachelor's degree in mechanical engineering and a master's degree in applied mechanics, both from Northern Illinois University.

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