After enjoying a multi-year bull run, equities may be in for greater volatility ahead. Nevertheless, exchange traded fund investors can still keep their toe in stock market but hedge against large drawdowns through a low-volatility strategy as a way to potentially generate steadier returns over the long run.
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While not as glamorous as high-flying growth strategies, a low- or minimum-volatility portfolio has helped generate better long-term, risk-adjusted returns.
The low-vol strategy targets stocks that have lower expected risk or less idiosyncratic risks. Specifically, the strategy focuses on equities that exhibit lower beta, a measure of volatility or systematic risk of a security to that of the overall market. Consequently, minimum volatility portfolios are comprised of stocks that exhibit lower market risk or beta.
Extensive research has gone over the so-called low-volatility anomaly of outperformance. As a more conservative strategy, low-volatility investments are expected to provide investors with smaller swings and boring returns. However, the strategy has historically outperformed with higher risk-adjusted returns.
Market observers have attributed the outperformance to structural impediments and a behavioral bias. Specifically, structural impediments, or rules and restrictions that may make some investments off limits to certain investors, have fueled a preference toward high-flying stocks in hopes of higher returns.
Additionally, behavioral characteristics include the lottery effect where investors bet on a win in high volatile stocks; representativeness or the tendency to overpay for “glamorous” high volatility stocks; overconfidence in one’s ability to forecast the future; agency issue where people tend to eschew low-vol stocks due to less research; and asymmetric behaviors where low-vol stocks show smaller swings in both down and up markets.
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Whatever the case may be, the low-vol strategy has helped investors gain greater exposure to more conservative stocks that have held up during volatile market swings. For instance, the iShares MSCI USA Minimum Volatility ETF (USMV), which selects stocks based on variances and correlations, along with other risk factors, rose 6.1% year-to-date while the competingPowerShares S&P 500 Low Volatility Portfolio (SPLV), which tracks the 100 least volatile stocks on the S&P 500, increased 5.4%. In contrast, the S&P 500 Index only gained 2.5% after experiencing a market correction earlier this year.
The S&P 500's top three sectors include information technology at about 19%, financials 16% and health care 14%. However, these three sectors have been the worst performing areas so far this year.
On the other hand, SPLV includes a large 22.3% position in consumer staples, along with 16.5% industrials and 13.9% utilities, which are all in the green this year. While USMV also includes heavy tilts toward financials, health care and information technology, the underlying index's "optimization-based approach" has helped the fund take advantage of the correlation between stocks to design a low-vol strategy.
ETF investors browsing low-vol U.S. equity strategies may also consider a number of options. For instance, the SPDR Russell 1000 Low Volatility Focus ETF (ONEV) tracks large-cap U.S. stocks that demonstrate a combination of high value, high quality and low size characteristics, with a focus on low volatility. ONEV is up 5.5% year-to-date.
The Compass EMP U.S. 500 Volatility Weighted Index ETF (Nasdaq:CFA)consists of 500 of the largest U.S. stocks with consistent positive earnings, which are then weighted based on their standard deviation or volatility over the past 180 trading days. CFA is 4.2% higher year-to-date.
The Goldman Sachs ActiveBeta U.S. Large Cap Equity ETF (GSLC) screens for the low-volatility, along with common investment factors like value, momentum, and quality. GSLC rose 1.7% year-to-date.
The ALPS Sector Low Volatility ETF (SLOW) does bring something new to the low volatility ETF table. SLOW's underlying S-Network Sector Low Volatility Index applies equal weighting not once, but twice, so the holdings are equally weighted on an individual basis and at the sector level. Components are also taken from the S&P 500. SLOW increased 6.4% year-to-date.
The Legg Mason Low Volatility High Dividend ETF (Nasdaq:LVHD) selects U.S. equity stocks with low earnings volatility, along with relatively high yield and low prices, and the fund only selects profitable companies. LVHD increased 9.6% year-to-date.
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