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By Christine Benz and Alex Bryan | 12-26-2015 06:00 AM

Is a Low-Volatility Approach Right for You?

Low-volatility funds tend to offer a better risk/reward trade-off than the overall market, but the stocks therein will likely underperform in extended bull markets and could be more sensitive to interest rates, says Morningstar's Alex Bryan.

Christine Benz: Hi, I'm Christine Benz for Low-volatility strategies have been gaining traction in recent years. Joining me to discuss whether a low-volatility investment deserves a slot in your portfolio is Alex Bryan. He is an analyst with Morningstar.

Alex, thank you so much for being here.

Alex Bryan: Thanks for having me.

Benz: You noted in a recent article, Alex, that these low-volatility strategies have been gaining assets. We've seen a proliferation of products in this space. What do you think is driving that interest?

Bryan: Well, I think it's twofold. First, in the past several years, there have been a lot of academic studies that have been published that have shown that stocks with low volatility have historically offered better a risk/reward trade-off than the market overall. That makes for a pretty good marketing story. Now, on top of this, a lot of investors were looking for a lower-risk way to invest in stocks, particularly after their experience in 2008. So, I think it was a combination of this research push and investor pull that led to the creation of the so many new low-volatility strategies.

Benz: In terms of the product construction, most of these are index products, correct?

Bryan: That's right.

Benz: So, how do most of these funds attempt to winnow down the total stock universe to the low-volatility group?

Bryan: Most of these funds attempt to target stocks that have exhibited low volatility in the recent past. Now, different funds take different approaches to do this. For example, the PowerShares S&P 500 Low Volatility ETF (SPLV) basically targets the 100 least-volatile members of the S&P 500, and then it weights its holdings based on the inverse of their volatility so that the least-volatile stocks get the biggest weightings in the portfolio.

Now, iShares MSCI USA Minimum Volatility ETF (USMV) takes a more sophisticated approach. It uses a more complex algorithm to design a low-volatility portfolio with a couple of constraints in mind designed to preserve diversification. But it looks at not only individual-stock volatilities but also the correlations across stocks. So, it's a little bit more sophisticated, but they both try to get you to the same place.

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