3 Things You Need To Know About Low Volatility ETFs

by on April 15, 2013 | ETFs Mentioned:

During uncertain times, investors gravitate toward lower volatility equities and ETFs, as there is generally less risk attached to these products due to their more stable price action. But even during calm and high growth times, low volatility equities and ETFs have benefits. Growth within the ETF industry now provides investors with highly liquid vehicles for accessing a basket of low volatility equities. In good times and bad, there are several reasons to consider holding a low volatility ETF in your portfolio [see Free Member Report: How To Pick The Right ETF Every Time].

1. Low Volatility Does NOT Always Equal Low Returns

There is a common misconception that buying lower volatility equities or ETFs translates into lower returns. While there are times when low volatility may not make the high gains associated with some higher volatility stocks, a low volatility ETF can actually perform as well or better than some major benchmarks, in both up and down markets.

As a general rule, when broad based indexes are in decline or on a “shaky” advance, low volatility funds generally tend to do better than more volatile stocks, which are avoided or sold off due to their riskiness. When the market is trending up, higher volatility stocks are more in vogue and generally tend to outperform lower volatility ETFs.

While the market–gauged by the S&P 500 SPDR (SPY)–rallied 10% from January through March 2013, low volatility stocks, as measured by the S&P 500 Low Volatility Portfolio (SPLV), moved up nearly 12.5%. Therefore, low volatility stocks can actually outpace index benchmarks, even during a rising market [see S&P 500 ETFs: Comparing The “Twisted” Funds].

Figure 1. SPY vs. SPLV January Through March 2013. Source: StockCharts

Figure 1. SPY vs. SPLV January Through March 2013. Source: StockCharts (Click To Enlarge)

When the S&P 500 SPDR declined more than 8% in the autumn of 2012, the S&P 500 Low Volatility Portfolio dropped only 4% over the same period.

Figure 2. SPY vs. SPLV September 14 to November 16 , 2012. Source: FreeStockCharts (Click To Enlarge)

Figure 2. SPY vs. SPLV September 14 to November 16 , 2012. Source: FreeStockCharts (Click To Enlarge)

While it’s quite possible that low volatility stocks may underperform more volatile stocks, it is definitely not a rule. In fact, quite often, especially during uncertain times–even when the market is rising–low volatility stocks can bring in equal or better returns than a broad index that includes more volatile stocks [see Low Volatility Portfolio].

2. Use It as a Tool To Scale Back RiskLow Volatility

Uncertainty continually forces investors in and out of the market. Being forced to sell, or selling because the shares being held have become too risky, is very common. During good times, buying a basket of stocks such as the Dow Jones Industrial Average ETF (DIA) seems low risk until it begins to decline and it is more volatile than investors want.

Since market declines are inevitable, and occur on a regular basis, a low volatility ETF allows you to scale back your risk to a more comfortable level. As the prior section showed, this doesn’t even necessarily mean you’re giving up the chance at a decent return [see 101 ETF Lessons Every Financial Advisor Should Learn].

You still get to participate in the capital growth potential of the stock market, but you are doing so using a product that generally has lower downside risk than other ETFs and individual stocks, which have higher volatility. For example, USMV has a beta of 0.79, while SPY has a beta of 1.04 (as of March 28, 2013).

3. Use It as a Core Holding

Instead of just buying these products during a market dip or when times are uncertain, low volatility ETFs can absolutely be used as core holdings. Investors often think of these products as “tactical tilts” instead of core products, but that doesn’t need to be the case. While these products appeal to more conservative investors, all investors can benefit from reducing risk. Especially when reducing risk doesn’t necessarily mean you cut back on your return potential (see point 1).

Many low volatility ETFs also offer attractive dividends, making them a useful core holding for income seekers. As of March 28, 2013, the annual dividend yield for SPY was 1.59%, while for SPLV it was 2.29% and for USMV, 1.75%.

Since low volatility ETFs are relatively new products–most of them having been introduced in 2011 or later–the long-term performance is unknown. Yet, since their inception, the low volatility ETFs mentioned thus far have done a great job of keeping pace with the S&P 500 in terms of returns–at times outperforming–all the while being lower risk  [see 10 Questions About ETFs You've Been Too Afraid To Ask].

Diversification or accessing foreign and emerging markets is another reason to consider low volatility ETFs as a core holding. If you’ve considered investing in emerging markets, but thought it too risky, there are ETFs to solve that. The MSCI Emerging Markets Minimum Volatility Index Fund (EEMV) has an annual dividend yield of 1.64% and a beta of -0.80. As of April 1, 2013 it is down 0.17% year-to-date.

Looking for bigger foreign exposure? The MSCI All Country World Minimum Volatility Index Fund (ACWV) gives access to 45 markets–both developed and emerging–acting as a great core holding for diversification, risk reduction and income. The fund has a beta of 0.73, is up 10.68% YTD (April 1, 2013) and has an annual dividend yield of 1.76%.

Bottom Line

Low volatility ETFs aren’t just for risk-averse investors. While the downside risk is typically less within a low volatility ETF, you aren’t necessarily giving up the potential for decent returns. On the contrary, over the last couple of years, low volatility ETFs have outperformed several major index benchmarks. Betas are lower in low volatility ETFs, exposing investors to less price fluctuations, and annual dividend yields are typically higher than offered by the S&P 500 SPDR ETF. Low volatility ETFs also provide access to foreign and emerging markets, for those looking for a less risky way to get international exposure.

[For more ETF analysis, make sure to sign up for our free ETF newsletter]

Disclosure: No positions at time of writing.