“While constraints like limits on sector, country, and stock weightings and nontargeted factor exposures can reduce a fund’s style purity, they often help more than they hurt,” according to Morningstar. “Such constraints can improve diversification, mitigating potential losses if particular sectors or holdings fall out of favor. Turnover constraints are less important, but they can help modestly reduce transaction costs.”
USMV uses a different approach, somewhat more complex approach relative to traditional low volatility products, but has its advantages as well.
USMV “takes a more holistic approach to portfolio construction. It uses an optimization framework, which takes into account both individual stock volatility and correlations across stocks estimated from their factor exposures, to build the least-volatile portfolio possible under a set of constraints,” notes Morningstar. “The fund gives greater weighting to more-recent return data, primarily focusing on the past 12 months for volatility and three years for covariance. This approach and the fund’s semiannual rebalance allow it to effectively adapt as risk in the market changes.”
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