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ETF Specialist

Defensive ETFs: Too Good to Be True?

Defensive strategies, like those followed by low-volatility ETFs, can produce better risk-adjusted returns while smoothing out the highs and lows of the market.

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Low-volatility strategies offer defensive exposure to the stock market, attempting to give investors a smoother ride with better performance during market downturns. In exchange, they tend to lag during strong rallies. That's an attractive trade-off for risk-averse investors. There are other ways to reduce risk, such as allocating a larger portion of a portfolio to cash or bonds and less to stocks. But low-volatility stocks will likely offer a better risk/reward trade-off than the broad stock market or a stock/bond portfolio of comparable volatility.

Intuitively, there should be a positive relationship between risk (the type that can't be diversified away) and return. Why else would investors bear the extra risk? And in fact this relationship generally holds up across asset classes: Lower-risk assets, such as investment-grade bonds, tend to offer lower returns than higher-risk assets like stocks. But among stocks, the relationship between risk (defined by market sensitivity--beta--or volatility) and return isn't as strong as theory predicts it should be.(1) In other words, low-risk stocks have historically offered better risk-adjusted performance than their riskier counterparts. (See the references below for further reading.)

Alex Bryan has a position in the following securities mentioned above: USMV, XSLV. Find out about Morningstar’s editorial policies.