The Low Volatility Way To Play Emerging Markets

Ex-U.S. equity exchange-traded funds have been popular destinations for investors for over a year, but some investors like the idea of skirting volatility in international markets. This is particularly true with emerging markets stocks.

The iShares Edge MSCI Min Vol Emerging Markets ETF EEMV is one of the premier ways for skittish investors to embrace emerging markets equities while reducing volatility. EEMV, which is about six and a half years old, follows the MSCI Emerging Markets Minimum Volatility Index. That benchmark aims to hold stocks with lower volatility traits than the MSCI Emerging Markets Index.

The rub with many low volatility strategies is that their upside capture rate isn't intended to be 100 percent. Conversely, these funds usually perform less poorly in bear markets. Over the past three years, the MSCI Emerging Markets Index has outperformed EEMV by a margin of better than 2-to-1.

How EEMV Trims Volatility

Different low volatility ETFs, regardless of emphasized geography, use different volatility-reducing methodologies.

EEMV “uses an optimizer to construct the least-volatile portfolio possible using constituents of the MSCI Emerging Markets Index under a set of constraints,” Morningstar said in a recent note. “The optimizer takes into account each stock’s volatility and how they interact with each other to affect the portfolio’s volatility. It uses this information to select and weight stocks from the parent index. However, the fund limits sector and country tilts relative to the MSCI Emerging Markets Index, exposure to individual names, and turnover, which reduces transaction costs.”

Low volatility emerging markets ETF are often lightly allocated to commodities-sensitive economies. For example, EEMV allocates just 3.3 percent of its combined weight to Brazil and South Africa. Plus, the ETF has no exposure to oil-heavy Russia.

Getting Defensive

Standard emerging markets benchmarks are heavily allocated to technology and financial services stocks, but low volatility ETFs, such as EEMV, lean defensive.

“Unsurprisingly, this fund’s sector allocation leans heavily toward defensive sectors, such as healthcare, utilities, and consumer defensive, compared with the category average,” said Morningstar. “Stocks in these three sectors account for 28 percent of the fund’s portfolio compared with the less-than-16 percent category average. This helps minimize volatility associated with economic risk. Similarly, this fund has a significantly lower allocation to sectors strongly affected by economic shifts, such as basic materials, consumer cyclical, financial services, and real estate.”

Over the past three years, EEMV has been 500 basis points less volatile than the MSCI Emerging Markets Index. During that period, EEMV's maximum drawdown was 550 basis points less than the developing world benchmark.

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