iShares Edge MSCI Eurp Mini Vol ETF €Acc (LSE:MVEU) - ETF price


ETF Report

iShares Edge MSCI Europe Minimum Volatility UCITS ETF EUR (Acc) MVEU

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PortfolioConstruction

The MSCI Europe Minimum Volatility Net Return Index attempts to create the least-volatile portfolio of stocks selected from the market-cap-weighted MSCI Europe Index. To do so, it uses the Barra Open Optimizer and the MSCI Global Equity Model, subject to several constraints. These constraints keep the stock weightings to 0.05%-2% of the portfolio, sector weightings within 5% of the MSCI Europe Index, and two-way turnover limited to 20%. The algorithm also applies constraints to limit tilts to other factors, such as value. While pure low-volatility portfolios hold only low-volatility stocks, this minimum-volatility portfolio may comprise average- to high-volatility stocks because of the risk-diversification benefits they bring to the overall portfolio and the constraints built into the optimiser. Overall, it is hard to identify why one stock is in the portfolio versus another. As per the end of May 2019, the MSCI Europe Minimum Volatility Index represents about 42% of the roster of constituents in its parent index. Not surprisingly, the index has greater exposure to defensive sectors, such as utilities, consumer defensive, and healthcare, relative to its category peers. It also has greater exposure to the real estate sector and less exposure to more-volatile sectors like energy, technology, and financial services. The portfolio includes around 184 stocks, with the largest 10 holdings accounting for 15% of total weight. The index is rebalanced semiannually in March and September.

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Fees

The fund has an ongoing charge of 0.25%, making it amongst the cheapest strategic-beta ETFs in the Europe large-blend category. It is also competitively priced relative to its plain-vanilla, market-cap-weighted counterparts. Its tracking difference (fund return less index return) for the past three years has been less than its ongoing charge. This is mainly because of differences in withholding tax treatment between the fund and the index, which enable the fund to enjoy lower withholding taxes in a number of countries. Securities-lending revenues may have also contributed to partially offset the fees. Other costs carried by the unitholder include trading costs when buy and sell orders are placed for ETF shares, including bid-ask spreads and brokerage fees.

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FundConstruction

This fund uses optimised replication to capture the performance of the MSCI Europe Minimum Volatility Net Return Index. As of this writing, the fund owns almost all the underlying constituents in the same proportion as its benchmark, but the portfolio managers have the flexibility to avoid trading certain companies if they don’t consider them fit. It also uses futures to mitigate tracking error risk. IShares engages in securities lending to enhance the fund’s performance, lending up to 100% of the securities in its fund. Parent company and lending agent BlackRock covers the operational cost involved in securities lending for a 37.5% stake in the revenue generated from this activity, while the fund keeps 62.5%. Securities lending exposes the fund to counterparty risk, or the possibility that the borrower will not return the securities it borrowed. To manage this risk, BlackRock takes collateral greater than the total loan value. Collateral levels vary between 102.5% and 112%. Acceptable collateral includes equities (up to 40%), government bonds, and in some cases cash. During the past 12 months--as of 31 March 2019--the fund lent out 13.7% of its assets under management (on average) with a maximum on-loan of 18.2% and generated 0.04% securities-lending return. BlackRock also provides indemnification for its iShares ETFs. If a borrower defaults and fails to return borrowed securities, BlackRock will replace them. The indemnification agreement is subject to changes without notice. IShares holds a dominant position in the European ETF marketplace by virtue of its comprehensive offering. The fund management process is robust. We value iShares’ strong fund management process, its highly experienced team, and its extensive internal network supporting the portfolio managers. Having said that, we take the view that the vast economies of scale generated by the BlackRock group could be better shared with investors in the form of lower ongoing charges.

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Suitability

IShares Edge MSCI Europe Minimum Volatility’s sensible approach to reducing volatility and its low cost should allow it to beat its peers in the long run. We maintain this fund’s Morningstar Analyst Rating of Silver.

This exchange-traded fund’s benchmark attempts to construct the least-volatile portfolio possible with stocks from the MSCI Europe Index, under a set of constraints. These include limiting turnover, exposure to individual names, and sector tilts relative to the MSCI Europe Index, which improves diversification but also reduces style purity. While pure low-volatility portfolios hold only low-volatility stocks, this one may comprise average- to high-volatility stocks because of the risk-diversification benefits they bring to the overall portfolio and the constraints built into the optimiser.

During the trailing three- and five-year periods, the fund’s returns have been high while its risk has remained low relative to the average fund in the Europe large-blend Morningstar Category, which includes active and passive offerings. The MSCI Europe Minimum Volatility Index has exhibited 20% less volatility than its parent index, while it has delivered a similar level of return over the past three years. In total return terms, the fund has benefited from favourable exposure to financials, utilities and healthcare stocks, but this was offset by the relative losses of energy, technology, and telecom companies in the portfolio.

The fund's defensive posture should help it weather market downturns better than its peers, while it will likely lag during strong bull markets. Investors should not expect it to generate market-beating returns, especially if they have entered the strategy at a relatively high valuation point. But this fund should offer a smoother ride and outperform most of its category peers in the long run on a risk-adjusted basis.

The ongoing charge of 0.25% makes this fund one of the cheapest in the category. In terms of tracking performance, like most of its rivals tracking Europe equity net return indexes, the ETF outperformed its benchmark because of favourable withholding-tax differences between the index and the fund.

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Fundamental View

Historically, less risky stocks (as defined by volatility or market sensitivity--beta) have offered better risk-adjusted returns than their riskier counterparts. This 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. Several other researchers found a similar pattern for stocks sorted on volatility.

Robert Novy-Marx, a professor at the University of Rochester, attributes low-volatility stocks' attractive performance 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 because there is no guarantee that low-volatility stocks will always have these characteristics. In fact, this fund’s underlying index explicitly limits its value tilt relative to the MSCI Europe Index.

While low valuations and high profitability likely contributed to low-volatility stocks' attractive historical performance, there is probably more to the story. Many investors care about benchmark-relative returns, which may cause them to favour riskier stocks that have higher expected returns in bull markets, reducing their expected returns relative to their risk. Similarly, neglected lower-risk stocks can become undervalued 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. Andrea Frazzini and Lasse Pedersen, two principals from AQR, develop this argument in their paper, "Betting Against Beta."

A limitation to all volatility-related strategies is their reliance on backward-looking risk measures. One can question the use of historic volatility as an indicator for expected risk in the future, even if the strategy incorporates other factors like correlation. There is no guarantee that the least-volatile stocks historically will remain so going forward. In fact, these stocks may become more volatile as more money flows into them and their valuations increase, as has been witnessed in recent years. In the wake of the financial crisis, low-volatility strategies have grown popular with risk-averse investors, and several funds have launched in an attempt to capitalise on investor demand. However, low-volatility stocks no longer trade at a discount to the market based on measures such as price/earnings and price/book. While low-volatility stocks will likely continue to offer better risk-adjusted returns than the broad market, their absolute returns may be less attractive going forward.

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Alternatives

Other Europe-domiciled ETFs that offer exposure to minimum-volatility strategies include Amundi MSCI Europe Minimum Volatility Factor and Ossiam iSTOXX Europe Minimum Variance. While the Amundi ETF offers the same exposure as this iShares fund, the Ossiam ETF uses a different methodology. As such, the fund’s risk/reward profile, as well as its country, sector, and stock composition may differ.

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