Beware the Pitfalls of Low Volatility ETFs

ETFs promising low levels of volatility have become increasingly popular of late, but investors need to be aware of the risks inherent in their benchmarks

Hortense Bioy, CFA 7 May, 2013 | 7:00AM
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The past couple of years have seen a proliferation of smart beta ETFs. Among these, low-volatility funds have attracted significant interest from investors seeking equity market exposure with some downside protection built-in. Low volatility strategies have been particularly popular among those investors who, having been burned by the 2007-2008 market crash, are still wary of high price fluctuations but need to go back into equities for the long-term capital appreciation that this asset class usually brings.

According to academic studies, low-volatility indices outperform the market over the long term, and with higher risk-adjusted returns to boot. Taken at face value, this counterintuitive finding sounds very compelling. However, it can be misleading. Low-volatility stocks can also experience periods of significant underperformance. As such, funds that track or are benchmarked against these indices present potential risks and pitfalls that need to be well understood. 

Perhaps the biggest risk worth highlighting is sector concentration. Low-volatility themed funds tend to be highly concentrated in defensive stocks. Take the example of three European ETFs that offer controlled-risk exposure to the S&P 500: the SPDR S&P 500 Low Volatility ETF (LOWV), the Ossiam ETF US Minimum Variance NR (LUMV), and the iShares S&P 500 Minimum Volatility ETF (MVUS). As their names suggest, they all follow different methodologies, and this results in significant differences in sector and stock allocations relative to the S&P 500. With a 64% combined weight in utilities, consumer staples and healthcare stocks, the SPDR ETF has the strongest concentration in defensive sectors, followed by the Ossiam and iShares ETFs with roughly 52% and 42% each. This compares to a 27% weight in defensives for the S&P 500. 

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
iShares Edge S&P 500 Min Vol ETF USD Acc GBP5,303.50 GBX-0.10Rating
SPDR® S&P 500 Low Volatility ETF63.21 USD-1.04Rating

About Author

Hortense Bioy, CFA

Hortense Bioy, CFA  is global head of sustainability research at Morningstar

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