This article was originally published on ETFTrends.com.
The recent market correction reminded investors that market volatility can swiftly knockdown a bullish run. Consequently, investors should consider incorporating an exchange traded fund strategy to limit potential downside risks.
For example, the VictoryShares US Multi-Factor Minimum Volatility ETF (NasdaqGS: VSMV) follows a two-step approach to improve upon the process used by other minimum volatility ETF offerings available today. The ETF has the potential to enhance returns and then optimize the portfolio with the aim of reducing volatility, whereas many minimum volatility strategies focus solely on the latter step.
The underling index "offers a next-generation approach to low-volatility investing," according to Nasdaq OMX. "It seeks to provide a smoother path to long-term capital appreciation. The Index employs a two-step approach that aims to deliver superior risk-adjusted equity returns."
In the first step, a multi-factor process is utilized to screen for the best securities in the US marketplace. The strategy first starts with a universe of mid- and large-cap U.S. companies taken from the Nasdaq US Large Mid Cap Index and then ranks the companies using a number of proprietary fundamental factors like dividend yield, sales growth and other financial metrics identified by a quantitative multi-factor selection process to focus on companies most likely to outperform the broader market.
After the securities are picked out, in the second step, securities are put through an optimizer to create weights that have expectations for minimizing volatility while also meeting other constraints that keep the index from leaning too far in any direction away from the market.
"The multi-factor model alone produced better performance with lower volatility than the S&P 500," according to a Nasdaq OMX research note. "After running the securities with their multi-factor composite scores through the optimizer, the historical results show how applying an optimization process allowed for even better performance while limiting volatility."
In contrast, other popular low-vol ETF strategies only select and weight companies that exhibit the least volatility from a broader benchmark like the S&P 500. However, VSMV takes the initial first step of screening for smart beta factors like momentum, quality, value and growth before incorporating an optimization tool to weight individual securities to minimize absolute volatility.
Other low-vol strategies don’t put their initial input into consideration and just start with the broad equities market. On the other hand, through a better starting universe of securities to select from, an investor can potentially gain exposure to a better optimized portfolio.
"The combination seeks alpha from the multi-factor screen, and lower volatility stemming from the optimized portfolio construction," according to Nasdaq OMX. "This results in a portfolio designed to participate in rising or bull markets, while outperforming during periods of heightened volatility or bear markets (best illustrated in the up/down market-capture ratio of the Index). Ultimately, the Index aims to provide superior risk-adjusted returns and a smoother path to long-term capital appreciation."
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