A smart beta exchange-traded fund is like any exchange-traded fund (ETF) with a twist: It attempts to outperform rather than match the performance of an index. To achieve this, the fund managers try to reduce one or more of the risk factors attached to investing, particularly volatility. It is not an actively-managed fund but keeping it on track generally requires more frequent rebalancing than a normal ETF would undergo.

Low volatility is, in fact, a preferred smart beta factor. Low volatility ETFs are geared toward investors who want to participate in the markets when they are moving up but prefer 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:

  • 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

Two of the largest low volatility ETFs are the Invesco S&P 500 Low Volatility ETF (SPLV) and the iShares Edge MSCI Minimum Volatility USA ETF (USMV).

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.”

Although SPLV fared well through September of 2016 and relative to the S&P 500, it nonetheless underperformed SPY during a late-year correction. This prompted a backlash against SPLV and against low volatility ETFs in general. Among other criticisms, analysts cited the lack of constraints used by the fund in its rebalancing as a potential cause of large sector bets and major shifts in the portfolio over time.

On Nov. 8, 2018, SPLV ended the day at $49.52. compared to $47.82 a year earlier. Its 52-week low was $44.46 while its high was $50.42.

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.

On Nov. 8, 2018, USMV closed the day at $56.55 compared to $51.63 a year before. Its 52-week high was $57.67 while its 52-week low was $49.71.

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 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 time.

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 great deal of new money, so capacity issues should be a concern to financial advisors. This has fueled a concern that low volatility ETFs may be over-invested and crowded.

Typically, low volatility ETFs are heavily weighted in financial, consumer staple and healthcare 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 may fall out of favor as do most trendy strategies. Perhaps that will happen in the next period of consecutive rate increases.

The Bottom Line

Low volatility is one of several popular smart beta factors. Low volatility ETFs have faced some criticism in recent years but remain a popular choice. Over time lower volatility stocks have done well. The performance of two of the 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.

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