Defensive Exposure to Stocks Abroad

Currency fluctuations tend to make foreign stocks more volatile than their U.S. counterparts. Currency hedging is a potential solution, but it can increase transaction costs and reduce tax efficiency. As an alternative, investors might consider a defensive international-equity strategy, like

This exchange-traded fund tracks an index that attempts to create the least-volatile portfolio possible with large- and mid-cap stocks listed in developed markets in Europe, Australia, and Asia, under a set of constraints. These include limiting sector and country tilts relative to the MSCI EAFE Index, which improve diversification. The fund doesn't just target the least-volatile stocks. It takes into account each stock's exposure to common risk factors and the covariances among them to better estimate how the holdings will contribute to the portfolio's overall volatility. This may be a suitable core holding for conservative stock investors.

The fund will likely offer a more favorable risk/reward trade-off than the broad market-cap-weighted MSCI EAFE Index. But because it is taking less risk, this won't necessarily translate into better returns. Investors should expect the fund to lag the MSCI EAFE Index during market rallies, hold up better during market downturns, and offer similar returns--or slightly less--over the long term.

Historically, the fund's index has even done better than that. From its back-filled inception at the end of May 1988 through April 2016, the MSCI EAFE Minimum Volatility Index outpaced the MSCI EAFE Index, with 78% of the volatility. This is consistent with independent studies, which have shown that low-volatility stocks have tended to offer better risk-adjusted returns than the market. Part of this attractive performance profile is due to low-volatility strategies' tilt toward stocks with low valuations and high profitability, two characteristics that have historically been associated with better returns.

But there is likely more to the story. Because they tend to lag during bull markets and may have lower expected returns than the market over the long run, low-volatility stocks may not be appealing to investors who are trying to beat a benchmark (like most active managers), especially because many are unwilling or unable to borrow to boost these stocks' returns (a prudent course for most). That may somewhat depress low-volatility stocks' valuations, allowing them to offer more-attractive returns relative to their risk. This is not necessarily the same as the traditional value effect, as many of these stocks often trade at comparable or slightly higher valuations than the market.

Fundamental View The low-volatility effect was first documented in 1972 by Fischer Black, Michael Jensen, and Myron Scholes. They found that stocks with low sensitivity to market fluctuations (low betas) generated higher returns relative to their amount of market risk than stocks with high sensitivity to the market. A similar relationship holds for portfolios sorted on volatility. Robert Novy-Marx, a professor at the University of Rochester, attributes low-volatility stocks' marketlike returns from 1968 to 2013 to their low average valuations and high profitability in his paper, "Understanding Defensive Equity." He argues that investors would be better off targeting stocks with value and profitability characteristics directly. This fund explicitly limits its value tilt to mitigate its sensitivity to the value effect.

There is merit to reducing volatility because it is directionally related to the probability of large losses. Investors can reduce volatility by substituting bonds for stocks. But low-volatility equity strategies, like this one, have a good chance of generating higher returns than a broad market-cap-weighted stock/bond portfolio of comparable volatility. This is because many investors face borrowing constraints and care about benchmark-relative returns, which encourages them to overweight riskier stocks. As a result, lower-risk stocks may become undervalued relative to their risk. Andrea Frazzini and Lasse Pedersen, two principals from AQR, develop this argument in their paper, "Betting Against Beta."

Not surprisingly, the fund has greater exposure to defensive sectors like telecom, consumer defensive, healthcare, and utilities than the MSCI EAFE Index and less exposure to the more volatile materials, consumer cyclical, financial services, energy, and technology sectors. It diversifies company-specific risk with over 200 stocks and less than 15% of the portfolio invested in the top 10 holdings. These are multinational businesses whose cash flows are generally less sensitive to the business cycle than average, such as Unilever, Swiss Re, and pharmaceutical giant GlaxoSmithKline. The fund has a smaller market-cap orientation than the MSCI EAFE Index. And while smaller stocks are often less profitable, the fund's holdings generated slightly higher returns on invested capital over the trailing 10 months through April 2016 than the constituents of the MSCI EAFE Index.

Relatively stable cash flows could make these stocks more sensitive to changes in interest rates than average. Interest rates generally rise during periods of economic strength. However, the fund's holdings may have less growth than the broad market to offset the negative impact of higher rates. That said, the prospect of rising rates isn't a big concern in many of the markets where the fund invests.

Japanese stocks account for about 30% of the portfolio, and stocks listed in the United Kingdom represent an additional 24%, positions that are larger than the corresponding values in the MSCI EAFE Index. In contrast, the fund has less exposure to stocks in the eurozone (13%) than the MSCI EAFE Index, reflecting the volatility of the region. The fund takes currency movements into account in its construction approach by measuring volatility and covariance with stocks' U.S. dollar returns.

Portfolio Construction The fund employs full replication to track the MSCI EAFE Minimum Volatility Index, which attempts to create the least-volatile portfolio with stocks from the MSCI EAFE Index. It draws on the Barra Equity Model for estimates of each stock's volatility, sensitivity to risk factors, and the covariances between them. MSCI then feeds this data into an optimization algorithm that selects the constituents and weightings expected to have the lowest volatility, subject to several constraints.

These constraints keep stock weightings between 0.05% and 1.50% of the portfolio, sector and country weightings within 5% of the MSCI EAFE Index (this limit is tighter for countries that represent less than 2.5% of the EAFE Index), and one-way turnover limited to 10%. The algorithm also applies constraints to limit tilts to other factors, such as value. These constraints improve diversification, allowing investors to use this fund as a core holding. But they may also reduce its style purity. Additionally, the model isn't fully transparent. It implicitly assumes that past volatility and correlations will persist in the short term, a relationship that has historically held. The index is reconstituted semiannually.

Fees The fund's 0.20% expense ratio is very reasonable for this strategy. In fact, it isn't much higher than the cheapest market-cap-weighted alternatives. The turnover cap helps limit trading costs. BlackRock engages in securities lending. This ancillary income partially offsets the fund's expenses. As a result, the fund lagged its benchmark by 6 basis points annualized during the past three years.

Alternatives PowerShares S&P International Developed Low Volatility IDLV (0.25% expense ratio) is one of the closest alternatives. It simply ranks international stocks by their trailing 12-month volatilities, selects the least-volatile fifth, and weights them by the inverse of their volatilities. Consequently, the least-volatile stocks receive the greatest weightings in the portfolio. However, IDLV does not constrain its sector or country weightings, and as a result, it can make concentrated bets. In contrast to EFAV, the PowerShares fund also includes Canadian stocks. It rebalances quarterly and does not apply any rules to limit turnover.

Investors interested in applying a low-volatility strategy to a global portfolio of stocks might consider

Similar to ACWV,

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