Stock market volatility has been part of the investing landscape in 2015. This volatility has pushed some investors into low-volatility exchange-traded funds (ETFs), which seek to minimize the effect of large market swings. The assets in such ETFs jumped by about 26% in the first four and a half months of the year.1 Low-volatility ETFs have been around for less than five years, but have already attracted $18.4 billion in assets.2
Low-volatility ETFs generally work in one of two ways. One type screens and weights the stocks included in an index—such as the S&P 500® Index—according to their volatility. The least volatile stocks are given larger weightings. This usually means including more utility and consumer staples stocks, which tend to experience smaller price movements than stocks in other sectors.
The other type of low-volatility ETF includes a broader universe of stocks and weights them based on how correlated, or linked, their price movements are with each other. While such ETFs don’t explicitly avoid volatility per se, their weighting methodology tends to result in holdings that negate each other’s price swings. This can result in less-volatile performance, whether the market is rising or falling.
Whether low-volatility ETFs make sense for you depends on your expectations for the market and your returns, says Michael Iachini, Managing Director of ETF and Mutual Fund Research at Charles Schwab Investment Advisory, Inc. “Low-volatility ETFs may be right for investors who aren’t necessarily pessimistic about the market but who would prefer to avoid large swings in the value of their portfolio,” he says.
One thing to consider with these ETFs is that limiting losses likely limits gains as well. In other words, when you invest in low-volatility ETFs you could be giving up some potential upside when markets are rising. “In a long-running bull market, lower volatility funds typically have a hard time keeping up,” Michael says.
Depending on the market segment, low-volatility ETFs may also have higher operating expenses than standard index funds, Michael says. That is because minimizing volatility generally requires more frequent rebalancing. For example, ETFs weighting U.S. large-capitalization companies by volatility tend to have higher expenses than other U.S. large-cap stock ETFs.
1Morningstar Direct as of 4/20/2015.