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.
Important Considerations
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.
“While constraints like limits on sector, country, and stock weightings and nontargeted factor exposures can reduce a fund’s style purity, they often help more than they hurt,” according to Morningstar. “Such constraints can improve diversification, mitigating potential losses if particular sectors or holdings fall out of favor. Turnover constraints are less important, but they can help modestly reduce transaction costs.”
USMV uses a different approach, somewhat more complex approach relative to traditional low volatility products, but has its advantages as well.
USMV “takes a more holistic approach to portfolio construction. It uses an optimization framework, which takes into account both individual stock volatility and correlations across stocks estimated from their factor exposures, to build the least-volatile portfolio possible under a set of constraints,” notes Morningstar. “The fund gives greater weighting to more-recent return data, primarily focusing on the past 12 months for volatility and three years for covariance. This approach and the fund’s semiannual rebalance allow it to effectively adapt as risk in the market changes.”
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