Low-Volatility Stock Funds: A Closer Look

When the market experiences volatility, investors often seek strategies that offer a smoother ride. One such strategy is investing in low-volatility stock funds. However, it's crucial to delve deeper into these funds, as portfolio construction and performance can vary significantly.

The Appeal of Low-Volatility Funds

Low-volatility funds aim to provide investors with a stock portfolio that exhibits lower volatility and better downside protection compared to regular stock portfolios. These funds are ideal for investors who want to maintain their stock exposure but feel uneasy about future uncertainties. The underlying concept is straightforward: stocks that experience less fluctuation than the overall market tend to perform better during challenging times while still performing well during favorable market conditions.

Despite their purpose of reducing volatility, low-volatility funds are not immune to drawdowns. An illustrative example is the performance of several funds in 2020. While these funds incurred losses similar to the market in February and March, they subsequently lagged behind when stocks rebounded.

The Importance of Portfolio Construction

To avoid pitfalls, investors must pay close attention to portfolio construction when considering low-volatility funds. Matthew Bartolini, Managing Director at State Street Global Advisors and Head of SPDR Americas Research, emphasizes the significance of the construction philosophy in factor investing. Factors such as sector biases can impact a fund's performance and overall returns. Thorough due diligence is crucial, and investors should have a clear understanding of their investments.

Two Approaches to Portfolio Construction

Morningstar's Ryan Jackson identifies two primary schools of thought for constructing low-volatility portfolios, as exemplified by two prominent low-volatility ETFs:

By thoroughly understanding the construction philosophy and composition of low-volatility stock funds, investors can make better-informed decisions and navigate the market more confidently.

Lower Volatility ETFs: A Closer Look

The quest for lower-risk investment options has led to the rise of lower volatility ETFs. These investment vehicles aim to provide investors with a more stable portfolio by tracking stocks with the lowest volatility. One such ETF is the Invesco ETF, which tracks the 100 stocks in the S&P 500 that exhibit low volatility regardless of their sector.

Sector Perspective and Portfolio Composition

Although the Invesco ETF employs a more straightforward approach, it tends to lean towards defensive sectors, such as consumer staples, utilities, and healthcare. This strategic emphasis comes at the expense of more cyclical sectors like information technology, communications services, and energy. Todd Rosenbluth, head of research at VettaFi, a financial research and data company, highlights the significance of this divergence from a sector perspective.

Divergent Performances

The performance of the Invesco ETF and its counterpart, the iShares ETF, has revealed stark differences. The iShares ETF, with a dividend yield of 1.86%, has recorded a meager gain of 0.81%, trailing behind the broader stock market's growth of approximately 9%. On the other hand, the Invesco fund, boasting a dividend yield of 2.4%, has experienced a decline of 6.76%.

Assessing Effectiveness

When assessing whether these strategies deliver on their promise of lower volatility, it's essential to analyze their performance over an extended period. Looking back at the past decade until September 2023, Jackson suggests that the SPLV only captured about 67% of the downside of the S&P 500. This result demonstrates a lower level of volatility, with shallower drawdowns compared to its parent index.

The iShares ETF presents a similar pattern, exhibiting lower volatility, shallower drawdowns, and a downside capture ratio of 71% against its parent index, the MSCI USA.

Limitations and Long-Term Perspective

It is important to acknowledge that these lower volatility ETFs are still subject to market risks. They may not offer complete protection in every drawdown. However, held over the long term, they have the potential to better shield investors from significant downturns in the market.

In conclusion, lower volatility ETFs, such as the Invesco ETF, provide an alternative investment avenue for those seeking a more stable portfolio. While their performance might vary from their respective parent indices, these ETFs have the potential to better mitigate risk and safeguard against market volatility.

Written by: Lauren Foster