By Samuel Lee
A handful of monster trades over the past few months have pushed assets in iShares MSCI All Country World Minimum Volatility ETF (ACWV) from $30 million to almost $300 million, making it one of the quickest growing exchange-traded funds. And for good reason--it's a great strategy.
I've pounded the table for low-volatility equities in previous articles (but for nowhere near as long as some others have). The evidence is persuasive. Low-volatility stocks have performed about as well as their higher-volatility counterparts--much better, actually, in foreign markets--but, obviously, with lower volatility and smaller drawdowns. The phenomenon is robust to period and market, volatility measure (it can be measured by windows ranging from 30 days to three years), and other factors known to boost returns such as momentum and value. The strategy has produced superior risk-adjusted performances in Treasuries, corporates, and futures. Academics have known since at least the '70s that high-beta stocks (which are practically equivalent to high-volatility stocks) didn't offer returns commensurate with CAPM's predictions. Amazingly, most investors and researchers ignored this property of financial time series until recently.
So, what makes ACWV in particular compelling? Well, the biggest low-volatility equity fund, PowerShares S&P 500 Low Volatility (SPLV), only applies the strategy to U.S. stocks. While we like SPLV, low-volatility strategies have produced higher excess returns in more-volatile, more-heterogeneous, and, presumably, less-efficient foreign markets. If investors are impressed by the mountain of historical evidence attesting to the low-volatility anomaly's existence, it makes little sense to only apply the strategy in the market where it is expected to help the least. That is why ACWV's recent spurt of asset growth is good news. Investors can now buy a global low-volatility equity strategy without worrying about untimely liquidation.
While the fund exploits what I believe is a real phenomenon, its construction is complicated and bears investigating.
ACWV tracks the MSCI All Country World Minimum Volatility Index, which aims to create the lowest-volatility portfolio possible with the securities in the MSCI All Country World Index, a global market-weighted index. MSCI uses an optimizer to set constraints to the minimum volatility version of the ACWI, including keeping stock weightings within 0.05% to 1.5% of the parent index, sector and country weightings within 5%, and one-way turnover under 10%. MSCI reconstitutes the index semiannually.
The optimizer relies on a Barra equity model for three key outputs: the risk factor exposures for each security in the MSCI ACWI, the covariances of all the risk factors, and the covariances of all the securities. The outputs are used to estimate a "minimum variance" portfolio. MSCI states that historically the optimizer has selected smaller stocks and stocks that display low idiosyncratic volatility. The model may help reduce inadvertent tilts beyond low-volatility equity exposure but introduces some uncertainty as to how the strategy will behave in the future.
Therein lies the main risk of the strategy. The model is complicated and opaque. The precise and rigorous methodology to select a few hundred stocks to represent the world market may not work as intended, resulting in tracking error to the parent ACWI higher than what MSCI projects. Despite this risk, I am confident the portfolio will be less volatile than its market-weighted parent index over a market cycle. It is not terribly hard to construct lower-volatility portfolios, so long as you are not purposefully trying to sabotage yourself.
Trade With Care
ACWV's respectable size overstates its secondary market liquidity. Most of its assets are probably held by a handful of institutions, so don't expect a lot of volume. However, this doesn't mean the fund is expensive to transact, regardless of what current bid and ask prices are telling you. As long as you use limit orders close to the intraday indicative value (which you can find on the quote page of Morningstar.com or on Yahoo Finance after appending ".IV" to the ticker), you'll likely get your order filled at a fair price. This sounds involved but really should be how everyone should transact all but the most liquid ETFs.
Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including BlackRock, Invesco, Merrill Lynch, Northern Trust, and Scottrade for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.