How to Ride Out Market Swings With Low-Volatility ETFs

Market gyrations usher in a growing crop of low-volatility indexes and ETFs.

By SHARE

Sometimes, being labeled "boring" is a compliment.

Standard & Poor's banks on the tame reputation of its Low Volatility Index, a measure of the 100 least-volatile stocks in the S&P 500, to attract long-term investors tired of extreme stock market gyrations. The index, launched in April, coincides with the rollout of several low-volatility exchange-traded funds (ETFs), which offer investors a relatively easy way to take advantage of this investing philosophy.

[See 20 Funds That Have Weathered Downturns.]

Low-volatility products target investors who want protection against sharp drops and are willing to sacrifice some market upside. Top holdings in the S&P Low Volatility Index are largely made up of utilities and consumer staples stocks, as might be expected, while financials, consumer discretionary, and other categories comprise slimmer slices of the index.

Specialized approaches to the stock market—beyond picks based on sector or market capitalization—are drawing a greater following, particularly during the market extremes of the past few years. In fact, in April, S&P simultaneously rolled out an index reflecting the exact opposite approach of its Low Volatility Index. The S&P 500 High Beta Index measures 100 constituents of the S&P 500 that are most sensitive to changes in market returns and are weighted in proportion to their market sensitivity, also known as beta.

"In today's market environment, there is increased interest in managing risk and finding a solution via ETFs. Investors are seeking 'smart beta' solutions," said Darek Wojnar, head of iShares product development at BlackRock, after his firm added to their low-volatility lineup in late October. "These funds can provide a complement to the core passive portfolio, helping to optimize risk-adjusted returns over the long term."

[See the 50 Best Funds for the Everyday Investor.]

Investors do gain some upside with this approach, but they're often left in the dust when a rally takes off. For example, if you calculate the 2009 performance of the current holdings of the S&P Low Volatility Index, their 19.2 percent gain lags the S&P 500's 26.5 percent return.

During tech booms, the gap tends to favor the broader S&P, since investors are piling into higher-risk stocks to take advantage of the run. Low-volatility stocks gained 126 percent for the eight years leading up to the dot-com peak in March 2000, well below the S&P 500's 307 percent rise.

But the longer-term performance comparison offers a different picture. The Low Volatility Index has returned 80 percent during the past 10 years, compared with the S&P 500's 42.9 percent, assuming reinvested dividends. In a 20-year period, which includes much of the boom 1990s, the index outruns the S&P 500 by nearly 2 percent, according to S&P.

Investors will note differences in the way funds track volatility. In addition to following beta, which measures the volatility of a stock relative to the overall market, some of the indexes and related funds use standard deviation, a measure of how much a stock's price departs from the average over a period of time. A few use what's known as minimum variance algorithms, a strategy that combines beta, standard deviation, and other measures.

[See 5 Ways to Measure Investment Risk.]

"The goal is to add stability to your portfolio, reduce volatility, and improve risk-adjusted returns," says Bill DeRoche, CEO of FFCM, which recently introduced the QuantShares series of market-neutral ETFs, including a low-beta offering.

"Market-neutral ETFs let individuals and institutions take advantage of sophisticated investment strategies in an easily tradable ETF," he says.

At least nine ETFs dedicated to buying low-volatility stocks have been launched during the past five months, with familiar fund families Invesco PowerShares, BlackRock iShares, QuantShares, and more bringing new products online. Some of the newest offerings provide international exposure.

[See 3 Ways to Make Sense of Market Volatility.]