A Low-Volatility Approach To Emerging Markets

| About: iShares Edge (EEMV)

By Patricia Oey

iShares MSCI Emerging Markets Minimum Volatility (NYSEARCA:EEMV) is suitable for use as a small core holding in a diversified portfolio and is a solid alternative to a cap-weighted emerging-markets index fund. This fund tracks an index that selects about 200 stocks from its parent index (the MSCI Emerging Markets Index) to form a low-volatility portfolio. Low-volatility strategies seek to exploit the observed phenomenon that portfolios with smaller price fluctuations tend to outperform portfolios with larger price fluctuations over the long term.

Thanks in part to the heterogeneity of the emerging-markets equity asset class, low-volatility strategies in emerging markets have historically resulted in a greater reduction in portfolio volatility relative to a cap-weighted index than what has been observed in U.S. equities. In other words, there is more diversity (lower correlations) among emerging-markets equities, which allows for greater reduction in overall volatility in an emerging-markets low-volatility portfolio. In 2008, when the MSCI Emerging Markets Index declined by 53%, this fund's index fell by 42%. EEMV's index also exhibited a similarly muted decline in 2011--falling 6% versus the parent index's decline of 18%. The low-volatility index's relatively muted drawdowns during these two market downdrafts explain much of the strategy's outperformance versus its cap-weighted parent index over the past five years.

Volatility is a fairly straightforward and consistent measure to use to screen securities across the emerging-markets equity universe, which is a very broad asset class comprising equity securities from about 20 different countries. Other rules-based strategies that rely on fundamental factors or accounting metrics to screen constituents can be subject to tilts driven by differences in accounting practices among the countries in the emerging markets. For example, a fund that screens for value names might be biased toward companies from countries where asset book values tend to be understated relative to market values. Or a fund could have an overweighting in countries that historically trade at lower valuations (for idiosyncratic reasons) relative to the rest of the emerging-markets universe.

Although EEMV is a minimum-volatility strategy, it is still risky. Record-low interest rates in the developing world over the past few years have helped drive strong fund flows into emerging-markets equities and bonds. A sudden reversal in capital flows, due to a sudden rise in global market volatility or weakening macro fundamentals in the emerging world, can negatively impact both asset prices and currencies and drive short-term volatility in this fund. Like most foreign-equity funds, this ETF does not hedge its foreign-currency exposure.

Fundamental View
The MSCI Emerging Markets Minimum Volatility Index has had a strong track record in emerging markets. Over the 10 years ended March 30, 2014, this ETF's index outperformed the MSCI Emerging Markets Index by an average of 400 basis points per year while exhibiting much lower volatility--it had a standard deviation of monthly returns of 19.2% versus 24.0% for the MSCI Emerging Markets Index over this period. Among passively managed emerging-markets equity strategies, it had one of the lowest drawdowns during the 2008 global financial crisis. But investors should note that while this fund will generally fall less during bear markets, it will also tend to underperform during bull markets.

In U.S. equities, the outperformance of low-volatility strategies can be partially attributed to the value and small-cap effects, but these factors have less of an impact in an emerging-markets minimum-volatility portfolio. Historically, the MSCI Emerging Markets Minimum Volatility Index has traded at higher price/earnings and price/book multiples, relative to the cap-weighted MSCI Emerging Markets Index. This is partly due to the fact that low-volatility portfolios have relatively less exposure to the government-controlled mega-cap stocks in the MSCI Emerging Markets Index that are currently trading at lower valuations. Russia, which has both a volatile equity market and currency, has historically traded at lower valuation multiples relative to its emerging-markets peers. Not surprisingly, Russia has accounted for 1% to 2% in the MSCI Emerging Markets Minimum Volatility portfolio, which is lower than its 5% weighting in the cap-weighted index.

As for sector exposure, EEMV has had higher weightings in telecoms, consumer staples, health care, and utilities and lower weightings in global cyclical sectors such as energy, materials, and technology relative to its parent index. These sector tilts should provide better exposure to local growth trends in emerging markets when compared with a cap-weighted fund.

Portfolio Construction
Minimum-volatility strategies can have high turnover and can include less-liquid securities. Given that transaction costs tend to be higher in emerging markets, a low-volatility index without appropriate liquidity screens could be very costly to replicate. Overall, we think this fund's index has incorporated appropriate screens to ensure its investability.

EEMV employs full replication to track the MSCI Emerging Markets Minimum Volatility Index, which seeks to create a minimum-variance (or lowest-volatility) portfolio of 200 holdings selected from the MSCI Emerging Markets Index, using an estimated security covariance matrix (the Barra Global Equity Model) and a number of constraints to limit turnover, ensure investability, and maintain sector and country diversification. EEMV's portfolio represents about 40% of the roster of constituents of its parent index. The portfolio is rebalanced twice a year in May and November. This ETF does not hedge its foreign-currency exposure. This index methodology is somewhat of a black box, as data are not available regarding the estimated risk inputs used for the covariance matrix. It is important to note that this index was launched on Nov. 30, 2009. Data prior to the initial calculation date reflect hypothetical historical performance.

This fund charges an annual expense ratio of 0.25%. Since its inception in October 2011, this fund's NAV performance has trailed that of its benchmark index by 29 basis points, annualized. The goal of an index fund is to provide the returns of the index, less fees, so overall, the fund has done a reasonable job tracking its index.

This fund's main competitor is PowerShares S&P Emerging Markets Low Volatility (NYSEARCA:EELV) (expense ratio 0.29%), which is also a relatively new fund. EELV holds a portfolio of the 200 stocks from its parent index (S&P BMI Emerging Plus LargeMidCap Index) that have exhibited the lowest volatility over the past year. This fund's index's methodology is simple and transparent--holdings are weighted by the inverse of their realized volatility and are rebalanced quarterly. Over the past decade, EELV's benchmark index has generated excess returns relative to its cap-weighted parent index that are similar to those that EEMV's underlying index have produced relative to its parent index, while exhibiting lower volatility (the index launched in Dec. 5, 2011, so performance prior to that date is back-tested).

This PowerShares fund did not track its index very well during its first year--in 2012, EELV lagged its benchmark by about 100 basis points. This drag can be attributed to a combination of turnover (that year, turnover was 50%, versus 31% for EEMV) and the fact that the index included a number of less-liquid securities. In December 2012, S&P introduced a new liquidity screen in order to exclude less-liquid securities. While the fund has subsequently exhibited better tracking, we think this type of change suggests that the index may have not been well-designed or that the index was not subject to rigorous testing to ensure its investability.

Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.