Low-Volatility Weights Help Smooth Out Riskier ETF Themes

Investors may venture into riskier asset categories, such as high-yield stocks, as they build out a diversified portfolio, but many can diminish risk in these various market categories through low-volatility weights.

“A more thoughtful way to capture the appeal of high-dividend stocks may require some combination of fundamental criteria and risk weighting,” Mannik S. Dhillon, Head of Investment Solutions, Product, and Strategy with Victory Capital, said in a research note. “Selecting the highest dividend-yielding stocks and then weighting them based on standard deviation or some measure of volatility could add an important layer of risk management and, ultimately, provide a viable alternative to traditional beta approaches.”

Many have turned to traditional market capitalization-weighted index funds to gain market exposure. However, these market cap-weighted investments come with their own risks, such as heavy tilts toward the largest companies or those that have been the best performers.

“The challenge with traditional market-cap weighting is it can lead to concentrations that erode the benefits of diversification,” Dhillon said. “While cap-weighted benchmarks can effectively measure a market, they are not always the best investment solution.

Alternatively, investors can consider strategic- or smart-beta ETF options that provide an different weighting approach to potentially minimize or eliminate some of the inherent limitations of passive cap-weighted investments.

Dhillon explained that strategic- or smart-beta strategies, like low-volatility weights, can be an effective tool that enhances a passive allocation and acts to counterbalance some of the limitations of traditional cap-weighted indexing methodologies.