For new investors, low-volatility exchange traded funds often sound appealing, but they can later prove frustrating due to lack of understanding about how they work in real time.
On the other, with a little bit of education, investors can benefit from the low-volatility factor and ETFs such as the American Century Low Volatility ETF (LVOL). Home to 98 stocks, LVOL attempts to deliver a lower volatility profile than the S&P 500.
For investors looking to reduce risk while not devoting an entire portfolio to bonds and cash, a strategy like LVOL has merit, particularly over long holding periods. That’s important because various research and studies show that the efficacy of low volatility is most likely to be realized over the long term. Conversely, it has the potential to disappoint over shorter time horizons.
“The low-volatility alpha has been robust since 1995. However, this solid spell was interrupted on three occasions: during the dot-com crisis of 1998-2002, the Great Financial Crisis of 2007-2009 and the COVID-19-crisis of 2020,” according to BNP Paribas.
As the bank noted, one of the points of interest in those examples of low volatility hitting stretches of under-performance is that those years were preceded by periods of out-performance by stocks with superior volatility traits.
The coronavirus bear market of 2020 provided a prime example of why investors need to take a long-term view of products such as LVOL. With the benefit of hindsight, it’s not a stretch to say that the bear market was an example of too much too fast. As such, the subsequent decline and rebound were both drags on low-volatility investing.
“Predicting the returns of low-volatility portfolios over short horizons, e.g. over a month or a quarter, is impossible, even assuming that portfolio constraints have no impact and that the portfolio is well balanced. Due to their defensive beta, we can say that low-volatility stock portfolios are likely to outperform the market capitalisation index when market returns are negative, but it is not certain they will,” added BNP Paribas.
Bottom line: Markets are unpredictable, and a low-volatility strategy is the antithesis of getting rich quick. It is, however, ideal for conservative long-term investors, indicating that an ETF like LVOL is applicable in many portfolios.
“Investors should consider the benefits of low-volatility strategies over the long term. Rather than chasing short-term performance, we advocate long-term discipline that brings the power of compounding,” concluded BNP Paribas.
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The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.