Recently, there has been a fad in the Emerging Market space. ETFs focused on "Low Volatility" have grown in AUM, but do investors understand the drawback of this Low Volatility ETF fad? The performance of iShares MSCI Emerging Market Minimum Volatility ETF (EEMV) has been strong, but its track record is very short (inception: 11/2011). Here is an overview of the fund as well as significant overlooked drawbacks of its construction.
OVERVIEW OF EEMV
The iShares Minimum Volatility Indices are designed to create a "Minimum Variance Portfolio." This is based off of Harry Markowitz's Modern Portfolio Theory. As a synopsis of the theory, it suggests that by using optimization (choosing a portfolio of assets exhibiting low volatility and/or low correlation to other assets within the portfolio), you can find portfolios with the highest return for a given level of volatility, as well as the minimum variance portfolio (the portfolio with the lowest expected future volatility). This ETF applies this theory at the stock selection level of the Emerging Market space. Below are a few of the notable points in the ETF's construction.
- The portfolio is rebalanced (re-optimized) semi-annually.
- The portfolio has the following constraints at Rebalancing:
-- Holdings Size (1.5% is largest weight at rebalancing)
-- Sector Weight (+/- 5% vs Index)
-- Country Weight (+/-5% vs Index)
MAJOR DRAWBACKS OF THE ETF & METHODOLOGY EMPLOYED
Since the methodology looks to create a "Minimum Variance Portfolio" using Optimization, the fund concentrates exclusively on Volatility and Correlation. Return is not an input in the optimization! Basically, the portfolio is being created with an emphasis on volatility and NOT return opportunities. It should go without saying that most rational investors are primarily focused on potential Rewards relative to Risk, and not solely focused on Risk (volatility)… By focusing on volatility, the portfolio is created with no outlook on the future return opportunities of the stocks within the portfolio. This is the near equivalent of buying a low volatility stock (i.e. buying JC Penney) without looking into the fundamentals or whether the business model is still intact or if it is broken. Surely, other ETFs also hold a basket of stocks with no outlook on the return prospects of the securities. The difference between this passive fund and other passive funds is that this stylized beta has many more risks than investors are aware of (see point 3)
IS HISTORICAL VOLATILITY REALLY THE BEST WAY TO OBTAIN LOW FUTURE VOLATILITY - AND IS THE RIGHT RISK MEASURE BEING UTILIZED?
If choosing stocks with low historical volatility and/or low correlations is such a great way of creating a "Minimum Volatility Portfolio," then why are there over 10 Emerging Market mutual funds that have lower 1-year and Since Inception (of EEMV) volatility than EEMV? Focusing on historical volatility clearly doesn't produce a portfolio with the lowest volatility. The funds with lower volatility than EEMV focus on the valuation of stocks (determining a stock's intrinsic value), which EEMV does not since returns are not an input into the construction of the ETF portfolio. To me and to active investors, the idea of holding a "low-volatility" stock that is trading above its intrinsic value is a risky venture. As a stock trades further above intrinsic value, the more risk we see (who wants to own a stock that has low historic volatility but is now 40% overvalued due to a broken business model or due to irrational current demand?). With no focus on return and rebalancing occurring only 2x a year, this portfolio is vulnerable to holding overvalued and/or broken business model stocks. It's this misplaced emphasis of risk that also warrants caution.
STYLE BIASED / INVESTORS ARE LESS DIVERSIFIED THAN LED TO BELIEVE
As previously mentioned, other ETFs also hold a basket of stocks with no outlook on the return prospects of the securities. The difference between an ETF focused on the broad MSCI EM Index and one that is focused on a very distinct subset of the index is that the diversification offered by the MSCI EM Index is far greater than that of the iShares MSCI Emerging Market Minimum Volatility ETF (ticker: EEMV). There are very strong levels of style bias inherent in EEMV, and with its short tenure, investors are yet to see this style bias effect work in bull markets. Since this ETFs inception through March 31, 2013, the broad MSCI EM Index is up 5.37% while EEMV is up 14.03%. The fund's performance was supported due to investor's strong preference for higher yielding assets (value oriented stocks dominate this theme). The low-volatility, high dividend names, which this ETF is very exposed to have helped to support its return. Since inception, the Tracking Error for this ETF versus the MSCI EM Index was a high 6.55%, ranking in the equivalent of the top 30th percentile of the mutual fund universe (the mutual fund universe was used since the majority of these funds are active funds and this was useful in comparing the ETFs tracking error rank among active investors who have higher tracking error than passive investors). With correlations now coming down and higher yielding investments now approaching the status of "overcrowded trade," I expect (my opinion) that the same high tracking error that came with the fund on the upside performance will also cause this fund to experience strong pains should a bull market in Emerging Markets form. Overall, once the strong performance over the fund's very short tenure is examined deeper, it can be seen that the strong stylized bias towards the value-oriented, low-volatility names were a tail-wind to the fund. This bias seems to have run its course with outsized return premia paid (perhaps overpaid for the level of risk), leaving future returns with less room to run relative to the MSCI EM Index. In my opinion, I expect the performance of this fund to unwind should a strong bull market form.
STOCK PORTFOLIO OPTIMIZATION FAILED DURING THE MOST RECENT FINANCIAL CRISIS:
A Minimum Variance optimization is best applied at the Asset Allocation level (choosing different strategies with low volatility and correlation to find a low volatility portfolio). This ETF applies that concept at the Stock Selection level (choosing different stocks with low volatility and correlation to find a low volatility emerging market stock portfolio). As seen during the recent financial crisis, the Modern Portfolio Theory was put to test and failed. Portfolios of stocks that were deemed to be diversified were not very diversified at all. At the Asset Allocation level, this concept has stronger theoretical underpinnings and worked better during the recent financial crisis since different strategies typically have very different and long-lasting characteristics and behavior (i.e volatility and correlation) from each other. Bonds will behave much differently than stocks, even during a financial crisis. A portfolio of stocks, however, wavered during the most recent financial crisis and the lack of "diversification" was made evident. There is no fundamental research proving that this type of optimization would work at the Stock Selection level since a portfolio of stocks behave more similarly than two unique strategies like Bonds and Stocks.