Recently, my colleague Dennis Hudachek wrote about new ways to access emerging markets beyond plain vanilla funds, such as using dividend-weighted emerging markets ETFs .
I thought I’d build on his discussion, taking it into the realm of low-vol funds. Mostly because it seems as if any new bit of information from Europe or the Federal Reserve sets the markets into an immediate rally or tail-spin. And when markets turn choppy, they’re often the choppiest in emerging markets.
Let’s look at iShares MSCI Emerging Markets Minimum Volatility Index Fund (EEMV - News) and the PowerShares S'P Emerging Markets Low Volatility Portfolio (EELV - News)—two funds that would appear to be quite similar, but are in fact rather different.
EEMV vs. EELV
Although both ETFs provide low-volatility plays on emerging market equities—they accomplish this differently.
iShares uses the MSCI Emerging Markets Index as the parent index to construct EEMV. The low-volatility basket is created using a co-variance matrix to weight securities in such a way as to achieve the lowest absolute volatility for the portfolio as a whole.
By diversifying risk and minimizing co-variance, price movements are able to offset each other—creating a smoother return stream.
In addition, the MSCI Emerging Markets Minimum Volatility Index also utilizes a capping system to maintain the integrity of the index. For example, the sector and country weights of the index can’t deviate more than plus or minus 5 percent from the respective weights of the parent.
Meanwhile, PowerShares’ EELV uses a benchmark of the 200 least-volatile equities in the S'P Emerging BMI Plus LargeMidCap Index. The constituents are then ranked by realized volatility , with the least volatile securities receiving the most weight.
No caps are introduced, and there’s no consideration for the correlation of securities with one another.
The graph below compares EELV’s and EEMV’s underlying low-volatility indexes to the MSCI Emerging Markets Index.
That broad index serves as the benchmark for the two most popular emerging markets funds:the $48.6 billion Vanguard MSCI Emerging Markets ETF (VWO - News) and the $33 billion iShares MSCI Emerging Markets Index Fund (EEM - News).
Over the past six months, EELV’s and EEMV’s underlying indexes returned 9.77 percent and 7.86 percent, respectively, compared to the MSCI Emerging Markets Index, which returned 3.92 percent.
Some of you may conclude at first blush that because of its outperformance since inception—EELV’s index is superior to that of EEMV. However, this isn’t necessarily true.
Typically, ETFs aimed at minimizing volatility make plays towards certain low-risk sectors such as utilities. Although EELV and EEMV do exhibit some of these tendencies, the real impact and differences between the two funds are felt in their country exposures.
Overall, EELV is a lot more concentrated than EEMV.
Malaysia, South Africa and Taiwan make up over half of EELV’s portfolio:Malaysia maintains the largest presence at 25 percent of total assets, followed by South Africa at 19.6 percent.
Meanwhile, EEMV is somewhat more diluted and restricted from deviating from its parent index too much—making it a more market-like basket than EELV.
Consequently, EEMV’s exposures to Malaysia and South Africa are considerably lighter, at 8.53 percent and 8.15 percent, respectively. Its largest holdings instead, are in Taiwan and China, at 15.57 percent and China at 12.86 percent.
Arguably, EELV has been able to outshine EEMV in the past couple months because of its play on Malaysia and South Africa.
Both nations have been outperforming other emerging markets handily. Over the past six months, the MSCI Malaysia IMI USD Net Index returned 9.27 percent, while the MSCI South Africa IMI USD Net returned 10.98 percent.
Going back to EEMV’s heaviest weights—Taiwan and China—the MSCI Taiwan IMI USD Net Index and the MSCI China IMI USD Net Index returned 5.65 percent and 4.83 percent, respectively.
As I suggested about drawing hasty conclusions on the basis of recent performance, EELV’s concentrated portfolio could easily go from being a blessing right now to becoming a curse later on.
When push comes to shove, this theme rings true with many low-volatility funds.
As an investor, are you buying sector and/or country-plays, or are you buying a less volatile version of what you currently own?
The example of these two funds illustrates this concept beautifully
EEMV holds more-or-less the same stocks as EEM, but optimizes to decrease volatility. EELV, on the other hand, is a low-volatility portfolio of emerging market equities—its biggest goal isn’t necessarily to be representative of the emerging markets space.