What Investors Need to Know About Low-Volatility Funds

A version of this article previously appeared in the June 2021 issue of Morningstar ETFInvestor. Click here to download a complimentary copy.

Low-volatility exchange-traded funds aim to give investors a smoother ride in stock markets. Being long stocks with less risk is a compelling proposition. So, it's little surprise that these funds have been popular. Over the trailing five years through February 2020, investors poured a combined $30.2 billion of their hard-earned savings into U.S. large-cap ETFs that focus on dialing down volatility. This represented 306% organic growth over that five-year stretch. But the early-2020 market meltdown and subsequent rebound have put them to the test, and many investors have gotten spooked. These funds saw $18.1 billion in net outflows from March 2020 through May 2021.

Here, I'll look at how low-volatility ETFs performed in the 2020 market downdraft and subsequent recovery, examine the differences among them, and share my thoughts on how investors might use them to manage risk in their portfolios.

The Best of One World

Low-volatility strategies are at their best when markets are at their worst. Exhibit 1 is a relative wealth chart that plots the growth of the MSCI USA Minimum Volatility Index divided by the growth of the Morningstar US Market Index. When the line slopes upward, the minimum-volatility index is outperforming the broad market index, and vice versa. The upward spikes coinciding with the bursting of the dot-com bubble, the global financial crisis, and the coronavirus pandemic are a testament to the strategy's efficacy; it has taken some of the sting out of stock-market drawdowns.

But there are trade-offs. Investors can't have the best of both worlds. Low-volatility strategies will tend to lag in bull markets. This is most evident in the downward slope of the line that spans the better part of the 1990s and more recently in the post-pandemic rebound. This is what investors in these strategies signed up for. But following the most acute episode of underperformance in the history of the MSCI benchmark, a lot of them clearly aren't willing to suffer through it.

A year-plus of underperformance isn't an indictment of these strategies. Over the long term, investors in low-volatility funds are betting that this trade-off between losing less on the downside and not gaining as much on the upside will result in marketlike returns with less risk. The nearly three decades of performance history illustrated in Exhibit 1 show that it has generally been a solid bet--over a long enough horizon.

Weathering the Storm

How did low-volatility ETFs weather the storm in the first quarter of 2020? In a word: differently.

We currently assign Morningstar Analyst Ratings to two of the 10 U.S. large-cap low-volatility ETFs. Invesco S&P 500 Low Volatility ETF SPLV is rated Neutral, and iShares MSCI USA Minimum Volatility Factor ETF USMV is rated Silver. During the pandemic-induced sell-off, USMV's maximum drawdown (the depth of its decline from its mid-February peak) was 33.1%. SPLV's maximum drawdown was 36.3%.

Gold-rated iShares Core S&P Total U.S. Stock Market ETF ITOT--a proxy for the broader U.S. market--experienced a maximum drawdown of 35.0%. USMV performed as expected during this episode; SPLV did not. That said, investors should not expect these funds to bat 1.000, outperforming the market each time it dips. The longer the time frame, the more likely it is you'll see this relationship hold. Indeed, from November 2011 (the first full month following USMV's inception) through May 2021, USMV and SPLV had respective downside-capture ratios of 62.8% and 60.8% versus the Morningstar US Market Index.

These funds' recent performance underscores three key points that investors must keep in mind when assessing the merits of these funds and deciding where they might fit within their portfolios: 1) You're trading upside participation for downside protection; 2) results may vary from fund to fund; 3) low volatility does not mean no volatility--just less.

Results May Vary

There are important, albeit nuanced, differences in the way low-volatility strategies are constructed. The disparity in USMV and SPLV's recent performances is a testament to that. Exhibit 2 provides further evidence. It shows the absolute value of the spread in the monthly performance of the best- and worst-performing funds among the 10 U.S. large-cap low-volatility ETFs that existed as of the end of May 2021 over the trailing three-year period through May.

USMV Versus SPLV

In the case of USMV and SPLV, these differences point back to the funds' overarching approach to portfolio construction. USMV attempts to build the least-volatile portfolio of stocks it can, choosing from the MSCI USA Index. SPLV's portfolio is made up of the 100 least-volatile stocks from the S&P 500. There's a distinction between combining stocks to form the least-volatile portfolio versus building a portfolio of the least-volatile stocks. At first blush, it may seem trite, but the complexion of these funds' portfolios is markedly different.

Exhibits 3 and 4 show the evolution of the funds' GICS sector exposures. The comparison illustrates the differences in their approaches. USMV's sector exposures are relatively stable because its index tethers its sector weights to those of its parent index. They can't stray more than 5% in either direction from this reference point. SPLV has no such restrictions in place, which can lead to large and persistent sector bets.

At the height of the market in mid-February 2020, utilities and real estate stocks made up nearly 47% of SPLV's portfolio. At that time, stocks from those same two sectors represented just 17% of USMV's portfolio. SPLV's exposures in these sectors explained just over half of its relative underperformance versus USMV from the mid-February peak to the late-March trough.

Methodological differences between these seemingly similar funds are important to understand, as they can lead to material differences in their long-term risk/reward profiles.

Less Volatility

Low volatility does not mean no volatility, just less. Low-volatility stock funds are still stock funds. They are designed to be less volatile than their selection universes, and there's no question that they have delivered based on that criterion. But it can be dangerous to equate "less" volatility with "low" volatility. The former is a more apt description and one that would better calibrate investors' expectations. The latter better describes assets that would better diversify equity risk, like high-quality bonds.

The most promising feature of these funds is that they could--in theory--help investors stay in the market during trying times, dulling the pain they experience each time they check the value of their portfolio. But I'm deeply skeptical that they can serve that function, and the massive outflow that these funds have experienced in the time since the March 2020 market bottom is evidence in the case against their palliative potential. I don't think most investors take comfort in losing relatively less when the market hits an air pocket. And they certainly don't like being left in the dust when it rebounds sharply off the bottom. Investors need to understand that while these funds may have a place in their risk-management tool kit, they are specialized implements. Less-volatile equity portfolios may have a place, but they rank well below setting aside a rainy-day fund, having an appropriate asset allocation, and going for a walk the next time you're tempted to tinker with your portfolio.

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