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The recent market volatility and precipitous slide in stock prices shines new light on low-volatility ETFs, a growing segment of the investment securities market.
But do low-volatility ETFs really minimize the most extreme of price fluctuations? And if so, what is the best use of low-volatility ETFs in an investment portfolio?
Let’s take a look under the hood and see how these alternative investment choices work – and if they can be a good fit in your investment strategy.
What Are Low-Volatility ETFs?
As their name implies, low-volatility ETFs will seek to hold a number of securities – usually from a benchmark index – that are less volatile in relation to other securities in the index.
For example, PowerShares S&P 500 Low Volatility Fund (NYSEArca: SPLV) targets 100 of the least volatile stocks in the S&P 500 index. Instead of allocating the portfolio assets by a cap-weighted measure (as with conventional S&P 500 index funds) SPLV weights the holdings so that the least volatile stocks receive the highest weighting.
The top holdings in SPLV are Clorox (NYSE: CLX), Airgas (NYSE: ARG) and Coca-Cola (NYSE: KO).
There are only about 30 low-volatility ETFs on the market now, and most of them have only been around for a few years. Therefore, with the lack of a long-term track record, it’s difficult to say with confidence whether or not low-volatility ETFs are more than just a good idea in theory.
SPLV is the oldest low-volatility ETF and it’s been on the market for just under five years. While the market has seen some volatility in the past few years – and especially in mid-2015 and early 2016 – it may need more time to prove its worth.
However, there is some evidence that shows promise for SPLV and other low-volatility ETFs.
How Low-Volatility ETFs Have Performed
If we again use SPLV as a litmus test for value in the low-volatility ETF arena, we can look back over the past few years, when volatility has spiked to high relative levels.
In the first four full calendar years of its existence, SPLV lagged in performance in 2012 and 2013, when volatility was average to low, but beat the S&P 500 in 2014 and 2015, when volatility increased as investors began to fret a rise in interest rates. Here’s a quick breakdown in price movement:
And the 2016 year-to-date performance through Jan. 22 has SPLV at negative 4.3%, which compares to negative 6.7% for the S&P 500. Another widely held low-volatility ETF, iShares MSCI USA Minimum Volatility ETF (NYSEArca: USMV) showed almost identical results.
From this perspective, low-volatility ETFs appear to be the genuine article: They offer investors a way to achieve reasonable returns with lower volatility.
Are Low-Volatility ETFs Right For You?
While low-volatility ETFs appear to provide investors what the product the name suggests, I believe that they are nothing more than an old idea repackaged in a new way. In other words, investors can create their own “low volatility” portfolio themselves, or they can simply buy a balanced fund.
For example, Vanguard Balanced Index Fund (VBINX), which is a blend of roughly 60% stocks and 40% bonds, offers low volatility compared to a stock index. It’s beating SPLV year-to-date in 2016.
Furthermore, most low-volatility ETFs end up looking and performing similar to value stock funds or a deep value stock like Berkshire Hathaway (NYSE: BRK-B).
Also, many investors do not place the minimization of volatility as their first priority in investing; they want to achieve the best returns over time with a portfolio that is suitable for their risk tolerance.
The bottom line is that minimizing volatility and producing reasonable long-term returns in a portfolio can be simply achieved by applying the timeless investing concepts of diversification and dollar-cost averaging.
However, low-volatility ETFs can be wisely used as a core holding in a diversified portfolio as part of an investor’s overall strategy.
Kent Thune is the owner of an investment advisory firm in Hilton Head Island, S.C. He personally does not hold any of the aforementioned securities. Under no circumstances does this information represent a recommendation to buy or sell securities.
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