Should you invest in low volatility equity ETFs?

Are you taking on too much equity portfolio risk?

In the ever-fluctuating world of financial markets, many investors grapple with the fear of significant losses in their equity portfolios. The reality that stock markets can plunge by 40% or more during a crisis is a source of anxiety that keeps countless investors awake at night.

While equities are essential for growth and building wealth over the long term, their inherent volatility poses a substantial risk that not everyone is comfortable taking on.

Too much risk causes erratic investor behavior

This volatility doesn't just impact portfolios; it affects peace of mind. Watching the value of hard-earned investments seesaw can lead to stress and emotional decision-making. The fear of a market downturn wiping out years of gains can cause investors to pull out of the market prematurely, potentially locking in losses and missing out on future recoveries.

The dilemma is clear: How can one enjoy the growth benefits of equities without being subjected to their wild swings?

Potential solution - low volatility equity ETFs

Low volatility equity ETFs is a strategic investment option designed to provide equity exposure while aiming to reduce risk. These ETFs focus on stocks that have historically demonstrated lower price fluctuations, offering a way to participate in the equity market's upside potential with potentially less turbulence. With low volatility equity ETFs, investors can breathe a little easier knowing their portfolio is built for smoother sailing, even when the market gets rough.

What are low volatility ETFs made of?

Low volatility ETFs are made of low volatility stocks. These stocks are shares of companies whose prices have historically exhibited less fluctuation compared to the broader market. These companies often operate in sectors that are less sensitive to economic cycles, such as utilities, consumer staples, and healthcare. The demand for their products and services tends to remain steady regardless of economic conditions, contributing to more stable earnings and cash flows.

Characteristics of low volatility stocks include consistent dividend payments, strong balance sheets, and reliable business models. They are typically well-established firms with a long track record of operational stability.

Investors may be drawn to these stocks for their potential to provide more predictable returns and to act as a defensive component in a diversified portfolio. While they may offer lower growth prospects during bullish market phases, their relative stability can help cushion a portfolio during periods of market turbulence.

Examples of low volatility ETFs

How does low volatility ETFs achieve lower volatility?

Low volatility ETFs achieve lower volatility primarily through their stock selection process. The goal is to assemble a portfolio of stocks that historically have exhibited less price fluctuation than the broader market.

• Low Volatility Screening: The ETF selects a subsection of stocks from the broad index with the lowest realized volatility over the past year.

• Realized Volatility Measure: Volatility is measured based on the standard deviation of daily returns over this time frame. Stocks with more stable (less volatile) price movements are favored.

• Equal Weighting by Volatility Weighting Methodology: Stocks in the ETF are weighted inversely to their volatility. This means: Less volatile stocks get a higher weight in the portfolio. More volatile stocks are included but with smaller weights. This allocation reduces the overall risk of the portfolio.

• Liquidity: Avoidance of less liquid stocks to ensure ease of trading.

• Diversification: Ensuring a broad mix of companies across different sectors and industries.

What are the drawbacks of low volatility ETFs?

1. Underperformance in Bull Markets

   Low volatility ETFs may lag behind the broader market during strong bull markets because they emphasize stability over high growth.

2. Higher Valuation Risks

   Low volatility stocks can sometimes trade at premium valuations. As these stocks become more popular among risk-averse investors seeking stability, increased demand can drive up their prices relative to earnings or book value. This overvaluation can lead to lower future returns, especially if market conditions change and investors shift back toward higher-risk, higher-growth stocks.

3. Sector Concentration

   They often have a higher concentration in certain sectors like utilities or consumer staples, which could impact performance if those sectors underperform.

4. Not Risk-Free

   While they aim to reduce volatility, they are still subject to market risks and can experience losses.

Who should consider low volatility ETFs?

Low volatility ETFs can be particularly appealing to investors who are risk-averse but still seek exposure to the equity markets. Retirees, for example, may prioritize capital preservation and steady income over aggressive growth.

Similarly, investors with a shorter time horizon or those who cannot tolerate significant portfolio fluctuations might find these ETFs align well with their investment objectives.

By providing a cushion during market downturns, low volatility ETFs offer a way to stay invested in stocks without enduring the full brunt of market swings.

Integrating low volatility ETFs into your portfolio

When considering low volatility ETFs, it's important to evaluate how they fit within your overall asset allocation. These ETFs can serve as a core equity holding or complement other investments to reduce overall portfolio volatility. Investors should assess their risk tolerance, investment horizon, and financial goals to determine the appropriate allocation.

Additionally, it's wise to diversify across different low volatility ETFs or combine them with other asset classes, such as bonds or international equities, to enhance portfolio resilience.

Final thoughts

Low volatility ETFs are a good option for reducing portfolio risk and achieving smoother returns. However, investors must weigh the drawbacks—such as sector concentration, lower growth potential, and valuation risks—against their financial goals. Diversifying with other strategies or asset classes can help mitigate these limitations.

Next Edition…

Stay informed and empowered with our weekly newsletter, delivering insights on markets, the economy, and innovation. Subscribe today and share with those who value smart strategies for long-term success!

If you want to chat with me, feel free to schedule a quick call