Inside the iShares Minimum Volatility ETFs

By Dan Bortolotti on December 3, 2012
Estimated reading time: 3 minutes

Last week we looked at two low-volatility ETF strategies based on beta and the standard deviation of daily price movements. Now let’s complete our roundup by looking at a third methodology used by MSCI, the index provider behind the new iShares family of low-volatility ETFs. This is one is completely different from the other two. MSCI’s strategy is based on creating what’s called a minimum variance portfolio, an idea that goes back to Harry Markowitz’s Modern Portfolio Theory in the 1950s. What makes this strategy unique is that the individual companies don’t matter much in isolation, or even relative to the market as a whole. What’s important is their correlation with each other: the goal is to combine stocks in a way that results in a portfolio with the lowest possible volatility. Think of it like a cake recipe where you add baking powder and salt—which can be unpleasant on their own—because they taste delicious when combined with the other ingredients. The methodology starts with a parent index that represents the broad market—such as the MSCI Canada Index—and then applies a number of rules to optimize that portfolio. Some companies are deleted from the index altogether, while those remaining are assigned whatever weight would lead to lowest overall volatility. (The specifics are complex, but you can read more on the methodology if you’re inclined.) Once you understand this strategy, you’ll appreciate why the iShares MSCI Canada Minimum Volatility (XMV) looks a lot more like a broad-market Canadian equity ETF than its counterparts, the BMO Low Volatility Canadian Equity (ZLB) and the PowerShares S&P/TSX Composite Low Volatility (TLV). The Big Five banks are all among the top holdings, for example:

	XMV Top 10 Holdings
	Royal Bank of Canada	3.3%
	CIBC	3.1%
	TransCanada Corp	3.1%
	Bank of Montreal	3.1%
	Bank of Nova Scotia	3.1%
	Toronto-Dominion Bank	3.1%
	Imperial Oil	3.1%
	BCE	3.0%
	Enbridge	2.9%
	Husky Energy	2.9%

Whereas the BMO and PowerShares low-vol ETFs are heavy on consumer retailers and utilities, these sectors play a small role in XMV. Energy, banks and materials are by far the biggest sectors in the iShares fund, just as they are in the Canadian market as a whole:

	XMV Sector Breakdown
	Energy	22.6%
	Banks	18.2%
	Materials	15.3%
	Food and staples	7.9%
	Insurance	7.1%
	Telecommunications	6.7%
	Utilities	5.7%
	Diversified financials	3.5%
	Real estate	3.0%
	Other	6.8%

US and international options, too

iShares also offers minimum volatility ETFs covering US equities, international equities, emerging market equities and an all-world fund. But these indexes bear less resemblance to their parents than XMV does. (The Canadian index, being smaller and less liquid that the giant US and international benchmarks, was subject to more constraints on the methodology.) For example, Apple is not even among the 122 companies in the iShares MSCI USA Minimum Volatility (XMU). Interestingly, none of these ETFs use currency hedging, since doing so would introduce a new source of volatility and completely change the profile of the funds. That makes the iShares MSCI EAFE Minimum Volatility (XMI) a lot more interesting. There is currently no Canadian-listed ETF that tracks the well-known MSCI EAFE index (Europe, Japan and Australia) without currency hedging, which is an expensive and dubious strategy with international stocks. So XMI seems like a reasonable alternative to the more popular international ETFs, even if it does hold just 172 companies, compared with 972 in the parent index. BlackRock has even capped the MER at 0.35% until the end of 2014, making it even cheaper than Vanguard’s EAFE fund. If you’re comfortable trading in US dollars, all of the iShares US and international low-vol ETFs are also listed in New York, and these versions have lower management fees.