ETF Exchange Traded Funds
May 15, 2015 - Low Volatility Emerging-Market Investing
One of Our ETF Picks for Emerging-Markets Exposure by Morningstar Investment Research
A low-volatility strategy can be a good option for emerging markets.
IShares MSCI Emerging Markets Minimum Volatility (EEMV) tracks an index that is designed to provide a less-volatile exposure to emerging-markets equities relative to a market-cap-weighted index. 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.
This strategy has had a good track record--as measured by the back-tested performance of this fund's benchmark index (the index's live performance commenced in November 2009). Over the trailing 15- and 10-year periods through April 2015, this fund's underlying index generated 408 and 335 basis points, respectively, of annualized outperformance versus the cap-weighted MSCI Emerging Markets Index, with significantly lower volatility. The minimum-volatility indexís standard deviation of returns during the past decade was 19%, while the corresponding figure for the cap-weighted index was 24%. The minimum-volatility index has also seen less dramatic drawdowns. Following the 2008 financial crisis, while the MSCI Emerging Markets Index had a maximum drawdown of negative 59%, this fund's index fell by 49% over the same time period. Likewise, in 2011, when this fund's index fell 6%, the cap-weighted index fell 18%. These relatively muted drawdowns explain much of the strategy's outperformance versus its cap-weighted parent index during the past five years. Investors should note, however, that while this fund will generally suffer less during bear markets, it will also tend to lag during bull markets.
Although EEMV is a minimum-volatility strategy, it is still risky. Record-low interest rates in the developing world during the past few years have helped drive strong portfolio flows into emerging-markets assets. A sudden reversal in flow, because of a sudden spike in market volatility or weakening macro fundamentals in the emerging world, could hurt both asset prices and currencies and drive short-term volatility in this fund. Like most foreign-equity funds, this exchange-traded fund does not hedge its foreign-currency exposure.
Historically, low-volatility stocks have outperformed high-volatility stocks over the long term. This "volatility anomaly" was first discovered in 1968 by financial economist Robert Haugen, who theorized that behavioral factors were behind this phenomenon. More specifically, investors tend to chase risky stocks, expecting these companies to deliver higher returns. This drives up stock prices of riskier names, which ultimately results in weaker future returns relative to less-volatile names.
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 in U.S. equities. In other words, there is more diversity (lower correlations) among emerging-markets equities, which allows for greater reduction in price fluctuations in an emerging-markets low-volatility portfolio.
This fundís index employs constraints to limit turnover and reduce exposure to less-liquid securities. Given that transaction costs tend to be higher in emerging markets, a low-volatility index without liquidity screens can be costly to replicate. The index also has country and sector caps; otherwise, this fund could see significant sector and/or country tilts. Over time, this fundís country and sector weightings can shift, but these changes tend to be gradual. Overall, we think this fund's index has incorporated appropriate screens to ensure its investability.
On a fundamental level, the tailwinds from a decade of strong gross domestic product growth and stellar equity market performance in emerging markets have faded. China is undergoing a transition from an investment-driven growth model to one more oriented toward consumer spending, and it is likely to face some growing pains in the medium term. Foreign fund flows have grown more volatile and have helped expose which countries have relatively weaker fundamentals, resulting in higher currency and local stock market volatility. Almost all emerging-markets countries appear to be settling into a period of slower GDP growth in the near and medium term, but there are notable differences. By region, Asia appears to be a relative bright spot. Growth in 2015 and 2016 is estimated at around 6%, as emerging Asia benefits from cheaper commodity imports and still-accommodative financial conditions. In contrast, weak commodity markets will likely continue to have a negative impact on Latin America; Brazil is expected to see its economy contract by 1% in 2015.
In the years leading up to the 2008 financial crisis, almost all of the individual emerging-markets countries exhibited very strong stock market performance. In these types of market environments, a minimum-volatility strategy (such as this fund) tends to underperform a market-cap-weighted strategy. On the other hand, when individual emerging markets exhibit very disparate returns, a minimum-volatility strategy tends to outperform a market-cap-weighted strategy. This fund may be a good option in the medium term given the variance in outlook across the emerging-markets universe in the coming years.
EEMV employs full replication to track the MSCI Emerging Markets Minimum Volatility Index, which attempts to create a minimum-variance (or lowest-volatility) portfolio of 250 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. Last year, this fund had a turnover of 30%. The index's methodology is something of a black box, as data are not available regarding the estimated risk inputs used for the covariance matrix. The portfolio is rebalanced twice a year in May and November. EEMV's portfolio represents about 40% of the roster of constituents of its parent index. That said, during the past decade, this minimum-volatility index has had a high correlation of 0.98 to its parent index. This index was launched in November 2009, so data prior to the initial calculation date reflect hypothetical historical performance.
This fund charges an annual expense ratio of 0.25%, composed of a management fee of 0.67% and a fee waiver of 0.42%. According to iShares, the fee waiver may be reduced or discontinued at any time without notice. During the past three years, this fund's NAV performance has trailed that of its benchmark index by 18 basis points annualized, which is very close to its expense ratio. 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.
Another low-volatility option is PowerShares S&P Emerging Markets Low Volatility ETF (EELV) (expense ratio 0.29%). EELV holds a portfolio of 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 transparent: Holdings are weighted by the inverse of their realized volatility and are rebalanced quarterly. This methodology is different from that employed by EEMV; as a result, the two funds tend to have fairly different portfolios.
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 high turnover 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, it is possible that prior to the change, the inclusion of less-liquid names were contributing to the indexís outperformance. It may be too soon to draw this conclusion.
Those interested in using a low-volatility strategy for other areas of their portfolio can check out iShares' family of minimum-volatility ETFs.
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What Is An Exchange Traded Fund?
An exchange-traded fund or ETF is an investment vehicle traded on stock exchanges, much like stocks or bonds. An ETF holds assets such as stocks, bonds, or futures. Institutional investors can redeem large blocks of shares of the ETF (known as "creation units") for a "basket" of the underlying assets or, alternately, exchange the underlying assets for creation units. This creation and redemption of shares enables institutions to engage in arbitrage and causes the value of the ETF to approximate the net asset value of the underlying assets. Most ETFs track an index, such as the Dow Jones Industrial Average or the S&P 500.
An ETF is Like a Mutual Fund and a Closed End Fund
An ETF combines the valuation feature of a mutual fund or unit investment trust, which can be purchased or redeemed at the end of each trading day for its net asset value, with the tradability feature of a closed-end fund, which trades throughout the trading day at prices that may be substantially more or less than its net asset value. Closed-end funds are not considered to be exchange-traded funds, even though they are funds and are traded on an exchange. ETFs have been available in the US since 1993 and in Europe since 1999. ETFs traditionally have been index funds, but in 2008 the U.S. Securities and Exchange Commission began to authorize the creation of actively-managed ETFs.
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