Lower Risk & Higher Returns With This ETF

October 29, 2014

A low-volatility emerging markets ETF outpaces its plain-vanilla counterpart as it marks its three-year anniversary.

Low-volatility funds are hardly new. You might even think of them as past their prime, given all the buzz about them a few years back.

Still, a low-vol ETF covering the tricky emerging market space just hit its three-year mark, and its numbers are undeniably good. Volatility is no small part of emerging markets, with huge swings in Brazil as “Exhibit A,” so the notion of taming this risk has intrinsic appeal.

The fund is the iShares MSCI Emerging Markets Minimum Volatility ETF (EEMV | B-64) which offers a low-vol take on the hugely popular iShares MSCI Emerging Markets ETF (EEM | B-97). (Nerd alert: EEMV is actually min-vol, not low vol. That means its min-vol portfolio weighs correlations while low-vol funds ignore basic portfolio math.) EEM is a perfect fund to compare with EEMV.

Here are the facts for EEMV since its launch three years ago, using EEM as a yardstick:

1) Lower Risk

EEMV delivered on its min-vol promise: Its volatility of 10.9 percent handily beat EEM’s 14.3 percent. For reference, U.S. equities, as measured by the SPDR S&P 500 ETF (SPY | A-97), had volatility for the same period of 13.1 percent—significantly higher than EEMV’s. I calculated the downside risk too—the variability of negative returns—and found similar numbers for all three funds.

2) Higher Return

EEMV’s annualized three-year return of 9.5 percent trounced EEM’s 4.8 percent.

EEMV EEM risk rtn

 

 

3) Risk-Adjusted Outperformance

Yup, if higher returns and lower risk sounds like alpha to you, you’re right. We found statistically significant risk-adjusted outperformance over the past three years of 4.9 percent annualized. That’s against our MSCI emerging markets benchmark, which is extremely similar to the index tracked by EEM.

4) Better Diversification

Many U.S. investors come to emerging markets in part for lower correlation to their U.S. equity allocation—often the largest part of their portfolio. Here again, EEMV’s correlation of 0.38 beats EEM’s 0.48, using SPY as a proxy for U.S. equity. (Returns with 1.00 have perfect correlation.) Lower correlation means better diversification mojo for investors with sizable U.S. equity allocations.

Correlation

What To Expect Going Forward

EEMV’s performance has been sterling over the past three years, as the numbers above show. Will it continue? I believe only one of the four bullet points above can be firmly counted upon going forward, but that doesn’t doom the fund’s appeal. Let me explain.

The only attribute I expect to persist is lower volatility. EEMV should deliver a smoother ride than EEM for two reasons. First, the fund’s math works. Second, I expect the future to be like the recent past when it comes to volatility and correlation—relative to EEM.

 

Given that EEMV takes less risk, I don’t expect it to deliver higher returns than EEM going forward, nor do I expect risk-adjusted outperformance.

I’m not sure what to make of EEMV’s lower correlation over the past three years. My guess is that hot money flows in and out of EEM much as it does with SPY in a risk-on, risk-off manner, while big-time traders avoid EEMV.

This theory holds up only to the extent that ETF flows transmit their impact to the underlying securities, which ultimately set the fund’s value.

The Case

So what’s the appeal for EEMV if the expectation is lower risk and lower return versus EEM. Why not simply allocate less to EEM and more to cash to achieve the same effect? (We calculate EEMV’s beta to be 0.79, which argues for a roughly 80/20 EEM/cash mix.)

That’s the classic finance approach, but it raises questions of its own:

  • Do you have the discipline to bear the volatility of EEM, even in a smaller allocation?
  • Are you willing to accept cash’s return, which may be negative in real terms?
  • Are you timing the mix of exposure to the cash and EEM based on your assessment of risk and opportunity, and if so, will you get it right?

In all, I argue that EEMV makes a viable long-term emerging market equity allocation for those who want to decrease their risk while participating in the potential upside from growth and diversification benefits. Kudos to those who reached this conclusion three years ago.

 


 

At the time this article was written, the author held no positions in the securities mentioned. Contact Paul Britt at [email protected].

 

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