Global diversification with a smoother ride

This low-volatility global equity ETF can offer more diversification benefits than its average category peer.

Patricia Oey 30 June, 2015 | 5:00PM
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iShares MSCI All Country World Minimum Volatility (XMW) tracks an index that is designed to be less volatile than its market-cap-weighted parent index, the MSCI All Country World Index (ACWI). It does so by holding units of a U.S.-listed ETF of the same name that trades under the symbol ACWV. Low-volatility strategies seek to exploit the observed phenomenon that a portfolio of stocks with smaller price fluctuations tends to outperform a portfolio of stocks with larger price fluctuations over the long term.

Historically, the correlation between this fund's U.S. version and the S&P 500 Index has generally been lower than the correlation between the average world-stock fund and the S&P 500. So even though it has a 54% weighting in U.S. equities, XMW (and ACWV) does have the potential to provide better diversification (relative to the average world-stock fund) for an investor with a large exposure to U.S. equities.

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 started in November 2009. Over the trailing 15 and 10 years through May 31, 2015, this fund's underlying index generated 400 and 200 basis points, respectively, of annual outperformance versus the cap-weighted MSCI ACWI. The minimum-volatility index had a correlation of 0.92 to its parent index over the past decade, but during the past three years this correlation was lower, at 0.76. The risk-adjusted returns were also relatively strong, with 15-year Sortino ratios of 0.94 for the minimum-volatility index and 0.34 for the cap-weighted index. However, low-volatility strategies can underperform for long periods of time and tend to lag in bull markets. This fund is suitable for use as a core holding for long-term investors.

Typically, global-equity funds are more volatile than domestic equity funds, as the former have exposure to both international equities and the associated foreign-currency fluctuations. But because global equities are a heterogeneous asset class, there is greater diversity (as evidenced by lower correlations) among its constituents, which allows for greater reduction in overall volatility in a fund that employs a minimum-variance strategy such as XMW. In fact, the trailing five-year standard deviation of returns for this fund's index of 8% (measured in U.S. dollars) was significantly lower than its corresponding cap-weighted index's 14%. XMW's index was also less volatile than the S&P 500's 12% during that same span. Part of this is due to the benchmark's lower drawdowns during bear markets. In 2008, when the MSCI ACWI fell 42% and the S&P 500 fell 37%, this fund's benchmark index declined 25%.

Neither the Canadian-listed XMW nor the U.S.-listed ACWV hedges its currency exposure, so their returns reflect both asset-price changes and translation effects as the value of the funds' holdings are converted into Canadian or U.S. dollars, respectively. Since the beginning of 2015, the Canadian dollar has declined significantly, notably against the U.S. dollar, the UK pound and most Asian currencies, leading to solid returns for XMW, while a strengthening U.S. dollar has hurt ACWV's performance.

Fundamental view

Historically, low-volatility stocks have outperformed high-volatility stocks over the long term. This "volatility anomaly" was first discovered in 1968 by Bob Haugen, who theorized that behavioural 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.

Generally, this fund had been heavy in less-volatile sectors including consumer staples, health care, telecoms and utilities and light in cyclical sectors including financials, technology, energy and materials relative to the MSCI ACWI. In 2013, the fund's greater exposure to less-volatile names in the United States and Japan weighed on its performance (relative to the MSCI ACWI), as higher-beta names outperformed in those markets. However, in 2014, the fund's underweighting in the energy sector boosted its relative performance. At this time, dividend-oriented sectors such as consumer staples and utilities have been bid up in the recent low-rate environment, and sectors such as materials and energy are trading at low valuations. This fund's tilt toward more-expensive sectors and tilt away from cheaper sectors may weigh on future performance.

About half of this fund's assets are invested in U.S. equities. Currently, the U.S. economy appears to be on stable footing. However, now that the U.S. Federal Reserve's quantitative-easing program has ended, there is uncertainty on how monetary policy will be managed and how it might ultimately affect asset prices--especially considering that valuations across most major asset classes appear to be somewhat stretched.

This fund's second-largest country allocation is Japan, at 13%. After two "lost decades," Japan's equity markets responded very enthusiastically to Prime Minister Shinzo Abe's programs to jump-start the Japanese economy. At the start of 2013, Japan's Central Bank unleashed an aggressive monetary easing program. This move provided the foundation for improving macroeconomic fundamentals and corporate earnings growth. Japanese equities may also benefit as Japan's public pension raises allocations in domestic equities and away from low-yielding government bonds. However, any sustainable economic growth in Japan will require structural reforms to address Japan's inefficient labour market and protected private sector. These issues have long been on lawmakers' agendas, and there has been little progress or improvement on these fronts during the past two decades because of strong, entrenched interests.

European equities comprise 10% of this fund's portfolio. Many European large caps are high-quality, multinational corporations that have benefited from improving productivity, cheap financing and exposure to faster-growing emerging markets during the past few years. Most of these firms are in good financial shape. This fund's largest European country allocations are Switzerland and the United Kingdom, and it has an underweighting (relative to the cap-weighted benchmark) in eurozone countries such as France and Germany.

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Patricia Oey

Patricia Oey  Patricia Oey is a senior manager research analyst for Morningstar.

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