Many smart beta exchange-traded funds (ETFs) invest in accordance with one of several factors. One popular smart beta factor is low volatility. Low volatility ETFs are geared toward investors who want to participate in the markets when they are moving up, but want to limit their downside risk a bit. Like most smart beta ETFs, low volatility ETFs can be used as a core holding in a portfolio or to add low volatility equity exposure to fine tune the overall risk of the portfolio.

Pros and Cons

Morningstar Inc. cites the following pros for low volatility ETFs: (For more, see: Smart Beta ETFs: The Pros and Cons.)

  • Lower volatility stocks tend to be more mature companies that are less dependent on continued economic growth.
  • Low volatility stocks have fared better on a risk-adjusted basis in many studies.

It also cites the following cons:

  • Low volatility strategies can lag significantly in up markets.
  • The increased popularity of low volatility strategies could result in lower risk-adjusted returns in the future.

Two Popular Low Volatility ETFs

The two largest low volatility ETFs are the PowerShares S&P 500 Low Volatility ETF (SPLV) and the iShares MSCI USA Minimum Volatility (USMV). (For more, see: Smart Beta ETFs Strategies.)

In regards to SPLV Morningstar says: “There is extensive historical evidence supporting a low-volatility approach to equity investing. However, the fund has a short live record. Since its inception in May 2011 through July 2015, the fund has provided about the same return as the S&P 500, with only 73% of the volatility. During that time, the fund's beta, or sensitivity of the fund to changes in the S&P 500, was only 0.6.”

Morningstar goes on to say: “SPLV tracks the S&P 500 Low Volatility Index. Each quarter this index targets the least-volatile 100 members of the S&P 500 over the past year and weights them by the inverse of their volatilities, as previously described.”

Through September 12, 2016, SPLV has done fairly well compared to the S&P 500:

  • Trailing five-year return of 14.76% versus 15.48% for the index.
  • Trailing three-year return of 12.20% versus 10.68% for the index.
  • Trailing one-year return of 16.90% versus 12.01% for the index.
  • Year-to-date return of 7.35% versus 5.71% for the index.

Clearly the ETF has held up well over the last year, a period of volatility and weakness for the stock market as a whole. However, the lack of constraints used by the fund in its rebalancing can lead to large sector bets and major shifts in the portfolio over time. (For more, see: Building a Better Mousetrap With Smart Beta ETFs.)

USMV tracks the MSCI USA Minimum Volatility Index. Unlike SPLV, USMV maintains sector weighting within 5% of the market cap weighted MSCI USA Index and limits turnover to 20% of the portfolio at each semi-annual rebalancing.

Through May 27, 2016 USMV has also done well compared to the S&P 500:

  • Trailing three-year return of 13.17% versus 10.68% for the index.
  • Trailing one-year return of 16.22% versus 12.01% for the index.
  • Year-to-date return of 8.46% versus 5.71% for the index.

Better Than Diversification?

Low volatility is a popular strategy, but financial advisors need to ask themselves if using a fund or ETF offering low volatility is a better long-term solution for clients than old fashioned diversification via the use of asset allocation. Many of the low volatility ETFs and funds are rather new and we won’t know for a number of years how they will actually perform over the course of a full market cycle. (For more, see: Are Smart Beta ETFs Active, Passive or Both?)

As with most smart beta strategies, many low volatility ETFs use a benchmark index that is carved out from a traditional market cap weighted index. Results prior to the actual inception of the product rely on back-tested results, which may or may not hold up as more money is invested in these strategies. Low volatility ETFs have been the recipients of a large amount of new money so capacity issues should be a concern to financial advisors. For example, USMV has gained about one-third of its current assets since the start of 2016.

Currently, low volatility ETFs are heavily weighted in financial, consumer staple and health care stocks. Low volatility strategies often hold high percentages of sectors like these plus telecoms and utilities that often behave like bonds, doing well in periods of falling interest rates. At some point these ETFs will eventually fall out of favor as do most trendy strategies. Perhaps it will be after the next rate hike if that turns out to be the start of a trend towards higher rates.

The Bottom Line

Low volatility is one of several popular smart beta factors. Low volatility ETFs have been very popular with the market volatility of the past year and inflows have been heavy so far in 2016. Over time lower volatility stocks have done well with less volatility than broader indexes like the S&P 500. The performance of the two largest low volatility ETFs has been solid since their inception compared to the S&P 500. These ETFs may have a place in client portfolios as either core or satellite holdings. Financial advisors who are considering using them should understand the make-up of the funds and their potential risks as well. (For more, see: What Advisors Need to Know About Smart Beta ETFs.)

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