A Way to Better Manage Equity Risk with a Low-Volatility ETF | ETF Trends

As investors look back into stocks, one may consider a de-risking ETF strategy that allows you to participate in the broad equity market and mitigate any further potential drawdowns.

On the recent webcast, De-Risk U.S. Equities with a Unique Low-Volatility Approach, Paul Kim, Managing Director – Head of ETF Strategy, Principal Global Investors; and Robert Hughes, Head of Nasdaq Investment Solutions, Nasdaq Global Indexes, helped put the current bear market in perspective. Historically, a bear market where the S&P 500 declined 20% more would experience a mean duration of 14.4 months with a mean maximum drawdown of 36.7% in the selling periods. So far, the S&P 500 has currently declined over 30% from its February 19 high.

As we return to equities markets, Jeffrey Schwarte, Portfolio Manager, Principal Global Equities, warned that investors should do their due diligence for U.S. large-cap if one is to seek risk mitigation since the traditional market capitalization-weighted fund strategies may come with unintended risks.

“Look for unintended concentrations in certain sectors or factors. Understand the tracking error. Set realistic performance expectations,” Schwarte said.

To better manage risk exposures, investors may consider a smart beta or customized index-based ETF strategy that adheres to a strict rule-following indexing methodology aimed at limiting downside risks while providing upside potential. Specifically, the Principal U.S. Mega-Cap Multi-Factor Index ETF (NasdaqGM: USMC) is comprised of companies with the largest market capitalization taken from the Nasdaq U.S. 500 Large Cap Index. USMC is a lower risk-oriented ETF, an increasingly popular strategy within the broader smart beta universe.

Matthew Cohen, Head of Principal ETF Specialist Team, Principal Global Investors, explained that USMC’s underlying index utilizes a modified equal-dollar weighting methodology where securities in the top 10% of aggregate market capitalization are weighted by market cap, but securities of the remaining companies are equally weighted and, in some instances, weights are adjusted to emphasize stocks with lower historical volatility and de-emphasize stocks with higher historical volatility.

The result is a portfolio that does not mirror your typical “low-vol” investment approach. For example, when compared to more popularly tracked indices like the MSCI USA Minimum Volatility Index or the S&P 500 Low Volatility Index, USMC’s underlying Nasdaq US Mega Cap Select Leaders Index exhibits a more significant tilt toward large-cap versus the benchmark S&P 500 Index. Additionally, USMC’s Nasdaq US Mega Cap Select Leaders Index exhibits lower volatility, slightly higher momentum and higher quality, compared to the S&P 500.

Moreover, due to its indexing methodology, the Nasdaq US Mega Cap Select Leaders Index takes on greater underweight to sectors like financial services, materials, real estate, utilities, and industrials, compared to the more widely observed MSCI USA Minimum Volatility Index or the S&P 500 Low Volatility Index. On the other hand, USMC includes a greater overweight toward sectors like healthcare, consumer defensive, communication services, and technology.

The Nasdaq US Mega Cap Select Leaders Index indexing methodology has helped USMC limit drawdowns and participates in market rallies, producing improved risk-adjusted returns over the S&P 500.

“It’s important to perform proper due diligence as you de-risk portfolios. An alternative weighted low-volatility approach to large-cap exposure can help mitigate risk. USMC allows investors to participate in the broad equity market with potentially less risk,” Cohen said.

Financial advisors who are interested in learning more about low-volatility strategies can watch the webcast on demand shortly.