Investing in low volatility stocks is a commonly used defensive strategy for investors who want to participate in some of the market’s growth while potentially reducing their downside risk.
However, research by FlexShares finds that traditional low volatility strategies may introduce unintended sector concentration and interest rate risk, among other challenges. This may be mitigated by applying the quality factor to a low volatility strategy, allowing an investor to capture more of the market upside potential while protecting against downside risks.
According to FlexShares, research conducted on stocks in the Russell 1000 Index between 1998 and 2016 found that the lowest quality stocks tended to experience higher levels of volatility, suggesting that incorporating a quality screen in a low volatility strategy may help further reduce volatility and add incremental returns.
The Northern Trust Quality Low Volatility Index historically has offered an upmarket capture ratio of 84% on average, while providing a downmarket capture ratio of 71% on average in comparison to the broad market index, according to FlexShares.
Investors can gain exposure to the index with the FlexShares US Quality Low Volatility Index Fund (QLV), which is designed to provide exposure to U.S.-based companies that possess lower overall absolute volatility and that also exhibit financial strength, stability, and quality characteristics.
Top holdings in QLV currently include Microsoft Corporation, Apple Inc., Johnson & Johnson, Eli Lilly and Company, and Home Depot, according to ETF Database.
With a 22 basis point expense ratio, QLV charges just half of what its factor strategy segment peers charge — 44 basis points, on average.
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