Investors seeking a way to navigate turbulent waters may want to consider the next evolution of low-volatility based ETF plays to provide a quality tilt to a low-volatility strategy within a diversified portfolio.
On the recent webcast, 3 Challenges with Low Volatility Approach Investments, Christopher Huemmer, Senior Investment Strategist, Northern Trust Asset Management, pointed out that low-volatility strategies are backed by empirical evidence and explained that behavioral economics may help explain low-volatility premia – behavioral biases may cause investors to chase after specific stocks, causing mispricing between market segments.
Investors should keep an eye on company stocks that exhibit low-volatility traits in today’s markets. Huemmer argued that equities still serve a purpose in a diversified investment portfolio, global yields are still depressed and the shifting demographics with a growing group of working millennials could further drive demand for stocks.
However, that does not mean the low-volatility strategy is risk free. Huemmer warned that the low-volatility investment methodology may limit upside potential, could come with high turnovers and exhibit sector or regional concentration risks due to the nature of the strategy.
Consequently, there are opportunities to refine the low volatility approach. For instance, in an attempt to overcome the low volatility limited upside capture, Huemmer argued that minimizing volatility at the portfolio level and including the quality factor historically allowed for stronger upside participation and downside mitigation. The same asymmetric upside-to-downside capture phenomenon experienced in the U.S. historically has been prevalent in emerging markets as well, which allows for an opportunity for a more refined low-volatility approach to international investing as well.
In addition, as a way to mitigate turnover and concentration concerns, Northern Trust’s FlexShares suite of quality low-volatility index ETFs seek to minimize overall portfolio volatility while controlling for sector and country biases and constraining turnover through an optimization process. For example, the underlying index for the FlexShares Developed Markets ex-US Quality Low Volatility Index Fund (QLVD) includes a +/- 5% cap on sector weights to target tighter sector exposures and a +/- 4% region cap on regions to target tighter regional exposures.
The indexing methodology of combining quality with low-volatility has helped the smart beta ETFs generate smaller drawdowns and still participate in upside potential as compared to broader benchmarks. For example, the Northern Trust US Quality Low Volatility Index, which is the underlying index of the FlexShares US Quality Low Volatility Index Fund (QLV), declined 9.7% in Q4 2018 compared to the S&P 500 Index’s 13.8% drop for the quarter, and the index slipped 2.4% during the May 2019 selloff compared to the S&P 500’s 6.4% retreat. Investors may also find that the quality low-volatility index strategies, including FlexShares Emerging Markets Quality Low Volatility Index Fund (QLVE), also exhibit lower drawdowns and upside potential compared to indexing methodologies that only focus on low volatility or minimum volatility.
This article originally appeared on ETFTrends.com.