Among smart beta ETFs dedicated to individual investment factors, low volatility products have been popular with conservative investors based on the premise that emphasizing a low volatility strategy can help reduce a portfolio’s downside potential.
The trade-off with ETFs such as the Invesco S&P 500 Low Volatility Portfolio (NYSEArca: SPLV) is that these funds are designed more to be less bad in bear markets than they are to capture to all of the upside during a bull market.
Investors considering low volatility ETFs should be mindful of key differences in how these funds are constructed.
“The most common statistical measures of risk that low-volatility funds use to select stocks are standard deviation of returns and market beta,” said Morningstar in a recent note. “Some also include fundamental measures of risk, such as volatility of earnings or leverage. However, one approach isn’t necessarily better than the others; while incorporating fundamental measures of risk can paint a more complete view of risk, they can also dilute the portfolio’s exposure to the least-volatile stocks in the market.”
The iShares MSCI USA Minimum Volatility ETF (Cboe: USMV), the largest US-listed low volatility ETF, selects stocks based on variances and correlations, along with other risk factors.
Different issuers and index providers arrive at a basket of low volatility stocks in varying fashions. For example, SPLV holds the 100 S&P 500 members with the lowest trailing 12-month volatility. That means, in a surprise to some investors, the fund is sector agnostic.