3 Low-Volatility ETF Strategies to Navigate Uncertain Market Conditions

Investors should consider the potential benefits of a low-volatility exchange traded fund strategy in an uncertain market environment to manage risk in their core investments.

In the recent webcast, How a Low-Volatility Strategy Can Help Mitigate Risk, Chris Dahlin, Factor & Core Equity Strategist, ETFs and Indexed Strategies, Invesco, described the current market environment as something similar to the mantra of “don’t fight the Fed” but only a different chapter in the same book. As the Federal Reserve embarks on a monetary tightening policy with a rising interest rate outlook to combat the elevated inflationary environment, we can expect lower household net worth and reduced demand. He noted that the housing market would be the first to soften, given their correlation to interest rates.

Meanwhile, equity volatility has historically moved with an inverse correlation to economic growth, which is expected to slow down or even contract. The slowing economic growth has also historically led to lower equity returns.

American consumers will also feel stressed as wage growth lags inflation, with the ability to save dwindling, Dahlin added.

Given the current market conditions, Dahlin argued that investors could turn to market factors to pursue specific returns, control risks, or both. Investment factors that can be expressed in investment strategies include value, size, momentum volatility, quality, and dividend.

As a way to better build a core, Dahlin advised investors to manage their volatility factor exposure. Academic research has found that lower-volatility stocks have historically generated better risk-adjusted returns over time. This is known as the so-called low-volatility anomaly, and it is the reason why many long-term investors have included low-volatility factor strategies in their portfolios.

Behavioral arguments have been attributed to explain the low volatility premium. Behavioral characteristics include the lottery effect, where investors bet on a win in high volatile stocks; representativeness or the tendency to overpay for “glamorous” high volatility stocks; overconfidence in one’s ability to forecast the future; agency issue, where people tend to eschew low-vol stocks due to less research; and asymmetric behaviors where low-vol stocks show smaller swings in both down and up markets.

To help capture this low-volatility factor, Invesco offers a suite of low-vol ETF strategies, including the Invesco S&P 500® Low Volatility ETF (SPLV), the Invesco S&P MidCap Low Volatility ETF (XMLV) and the Invesco S&P SmallCap Low Volatility ETF (XSLV).

The Underlying universes are the constituents of the S&P 500, S&P MidCap 400, and S&P SmallCap 600 Index, respectively. The least volatile quintile of stocks form the benchmark indices are selected. These stocks are then weighted by the inverse of their volatility, so the least volatile stocks receive the highest weights. Additionally, these Low-Volatility Indices are rebalanced quarterly every 3rd Friday of February, May, August, and November.

The long-term performances show that the low-vol strategy has proven to provide downside protection while providing upside potential. Specifically, looking at SPLV compared to the S&P 500, the ETF has provided an upside capture rate of 72% and a downside capture rate of 59% from 2011 through 2022.

Dahlin added that during drawdowns of +5% for the parent index, the low volatility strategy has typically outperformed. Specifically, SPLV, XMLV, and XSLV outperformed in 87%, 91%, and 89% of observed periods, respectively.

SPLV is not just another close clone of the S&P 500. Dahlin noted that SPLV’s return has been different than the S&P 500’s return, as seen by the influence of FAAMNG stocks. From 2011 through 2020, FAAMNG stocks have only contributed to 1.18% of SPLV’s overall returns. He also pointed out that the low-volatility indexing methodology is dynamic, with the potential to navigate away from volatility. For example, the utilities sector made up 32% of SPLV’s underlying portfolio back in April 2013, shrunk to 3% in July 2015, and now makes up 24.6% of the fund’s portfolio.

Invesco S&P Low Volatility provides pure access to the historically rewarded low volatility factor with a higher risk-adjusted return relative to the S&P 500, the potential for upside participation and downside risk mitigation, and risk mitigation and defensive equity exposure against the backdrop of a potentially slowing economy, according to Dahlin.

Financial advisors interested in learning more about the low-volatility strategy can watch the webcast here on demand.