What are low-volatility funds?

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In recent years, investors have been adding low-volatility investments to their portfolios. These are typically stocks and funds that are designed to fluctuate less than the overall stock market.

These investments often consist of stocks from certain sectors that have less volatility than the market as a whole (such as health care, grocery stores and utilities). They move up and down considerably less than other companies, such as technology or mining operations.

The idea of low-volatility investing has been around for years, but it gained momentum during the 2008/09 financial crisis. With some investors worried about stock market gains reversing or how geopolitics might impact their portfolios, and others just wanting to be prudent investors, low-volatility funds could continue to see considerable growth.

We explore the various types of low-volatility funds, and whether they’re worth considering. 

What are low-volatility funds? 

Low-volatility funds give exposure to a designated market in such a way as to experience less volatility than the overall market: a smoother ride is their primary objective. In practice, these funds are expected to lag the market slightly when times are good and offer better downside protection when markets fall. 

In exchange for giving up a little in expected returns when the markets go up, these funds tend to deliver fewer and less wildly unpredictable swings in value. Over the long term, this can translate into better risk-adjusted returns (higher returns for the risk taken), which makes these funds attractive to risk-averse investors. 

Why would you consider a low-volatility fund? 

While downside protection is the most obvious reason to look at low-volatility products, there are other advantages worth considering:

A smoother ride
Following periods of high financial turmoil (such as the period of COVID-19 lockdowns in 2020 and fears of a global recession in early 2016), many investors who prefer to avoid extreme market movements began using low-volatility funds. 

A toe in the water
For risk-averse investors, low-volatility funds can provide a less stressful entry point to equity investing. 

Confidence to stay invested
Investing in low-volatility funds can give investors more confidence to stay true to their “buy-and-hold” intentions. It can prevent them from reacting during downturns and exiting the market at the worst possible time.

Lack of recovery time
Sometimes the equity market can take a considerable time to recover from sharp sell-offs. Some investors, such as those nearing or in retirement, can’t afford to wait out an extended downturn. A low-volatility fund can help limit risk for these time-sensitive investors, while providing the potential upside from equities. 

Income
The sectors that many low-volatility funds focus on often come with above-average dividend yields. Investors looking for alternative income potential, especially in times of exceptionally low bond yields, may be drawn to some low-volatility offerings. These funds can also provide the income some investors need to avoid having to otherwise sell assets.

Higher risk-adjusted return
Published research demonstrates that low-volatility stocks tend to outperform the highest-risk stocks over time, and that portfolios built on low-volatility strategies can regularly result in higher risk-adjusted returns.1

Not all low-volatility funds are created equal 

Low-volatility funds can follow a wide range of strategies, from plain-vanilla large cap equity funds to alternative strategy funds, and everything in between. Within each of the approaches described below, a variety of strategies may be used:

Portfolios of low-volatility stocks
One of the simplest techniques is to build a portfolio of stocks that typically have less-than-average volatility. Some low-volatility U.S. ETFs, for example, simply hold the 100 stocks in the S&P 500 that had the lowest daily volatility over the past year. Some Canadian low-volatility ETFs are based on the S&P/TSX Composite Low Volatility Index, which selects the 50 least-volatile stocks from the TSX index. 

Historically, these portfolios of low-volatility stocks tend to deliver market-like returns with lower risk. However, on any given day (particularly during sharp downturns), investors are unlikely to see any appreciable difference in their performance, relative to the market.

Stocks with low correlations
Another popular approach is based on the correlation between individual stocks (the degree that stocks tend to move up or down in sync with each other).

Stocks that are uncorrelated (which move differently from each other), can balance each other out. This approach may be more effective at reducing overall portfolio volatility than stocks that may be less volatile but more highly correlated (which all move in the same direction). Each stock is then selected using a process that measures its impact on the overall volatility of the portfolio. 

More sophisticated approaches
Some low-volatility strategies develop proprietary risk models that attempt to incorporate other sources of risk exposures (such as excessively high valuations). The aim is to make these portfolios more adaptive to changing market environments and thus reduce risk more effectively. They can incorporate factors such as valuation, quality (for example, earnings stability) and momentum, to minimize the risk of exposure to low-volatility companies that have become dangerously expensive.

Some funds also employ derivative strategies or other complex hedging tools to further limit volatility. This could include selling call options to enhance the fund’s income and buying long-term puts on the index to reduce downside risk. Other funds’ objectives are to mitigate the frequency and magnitude of losses, and also to recover quickly. 

Potential risks and challenges of low-volatility funds

As low-volatility strategies become popular with risk-averse investors, it’s important to acknowledge that low volatility does not mean risk free. In pursuing a less bumpy ride, these strategies can expose investors to other risks.

Reliance on past risk data
There’s no guarantee that stocks displaying the least volatility historically will continue to do so in the future. Companies do change, so reliance on past risk data, such as historic volatility, may lead to unexpected results.

Opaque models
The more advanced the risk model is, the more likely the fund manager will consider it proprietary and keep the details hidden. As with any investment, it’s always advisable to understand the strategy employed, so you have a better idea of the risks involved and whether it’s appropriate for your portfolio. 

Underperformance in rising markets
Low-volatility funds are designed to dampen movements both to the downside and to the upside, compared to traditional funds. Therefore, in extended up markets, low-volatility strategies may miss out on significant gains.

Concentration
Some funds that focus only on historical volatility can have a dangerous over-concentration in certain defensive sectors, such as consumer staples, health care or utilities, or overexposure to risk factors such as interest rate sensitivity.

To counter this, some low-volatility funds exclude companies with the highest interest rate sensitivity and then, from the remaining available companies, select those with the lowest historical volatility.

Turnover

Depending on the frequency of rebalancing and sensitivity of optimizing models, some low-volatility funds could experience high turnover rates. The trading costs and tax liabilities could be an issue for funds held in non-tax-sheltered accounts.

Valuation

As with any niche investment strategy, a surge in popularity can worsen its future prospects. Too much money chasing a subset of the market with such a small base will drive up valuations and lower expected returns. Incorporating valuation into their risk models may help some low-volatility strategies mitigate this risk.

Outflows

When valuations become stretched, low-volatility funds may experience pronounced outflows if the market conditions that drove their popularity become more uncertain. As with any strategy focused on a narrow market subset, large outflows will have a negative impact on prices, and investors could suffer losses if there is a scramble to get out. 

Is a low-volatility fund appropriate for you? 

Low-volatility funds provide several potential benefits: a smoother ride, a way to cautiously enter the markets, encouraging the discipline to stay invested, income possibilities and the chance for higher risk-adjusted returns.

However, even if the potential risks are deemed acceptable, a low-volatility strategy may not be appropriate for everyone. These funds are designed to be held for several years. If you’re committed to a long-term investment period, then you need to decide whether it’s the right choice to potentially sacrifice long-term performance to avoid the daily or weekly ups and downs. 

There are several ways to reduce volatility beyond holding low-volatility investments. These include diversifying your holdings with uncorrelated assets and investing in asset allocation products, which are designed to deliver a similarly smooth ride.

An advisor can help you decide

Anyone with a long investment timeframe and a well-balanced portfolio shouldn’t need to worry about day-to-day volatility. However, if the stock market rollercoaster keeps you up at night, a low-volatility strategy could give you the peace of mind and confidence to stay invested over the long term.

Talk to an IG advisor to discuss the portfolio that best reflects your concerns. If you don’t have an IG advisor, you can find one here.

 

Source:

1 Morningstar: Do low-volatility ETFs deliver?

Written and published by IG Wealth Management as a general source of information only, believed to be accurate as of the date of publishing.  Not intended as a solicitation to buy or sell specific investments, or to provide tax, legal or investment advice.