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2 Winning Approaches During Volatile Times

These low-volatility funds practice very different strategies yet hold up well during market downturns.

Alex Bryan: The market has certainly exhibited a lot of volatility over the past year. Stock investors looking for a smoother ride and better downside protection than traditional index funds might consider a low-volatility stock fund. Well-constructed, low-cost funds like Invesco S&P 500 Low Volatility ETF and iShares Edge MSCI Minimum Volatility USA ETF should offer a better risk/reward trade-off than the market over the long term. These funds take very different approaches to reduce volatility, but they are both pretty effective.

The Invesco S&P 500 Low Volatility ETF is the more style pure of the two funds. It targets the least volatile 100 stocks from the S&P 500 and weights them by the inverse of their volatility, so that the least volatile stocks get the biggest weightings in the portfolio. As you might expect, this tends to pull the portfolio toward less volatile stocks like Waste Management and the Hershey Company, which tend to hold up a bit better than most during market downturns. However, this fund does not consider the correlations across stocks within the portfolio and it does not limit its sector weightings, which can lead to pretty big bets on sectors like utilities and REITs.

Now, in contrast, the iShares Edge MSCI Minimum Volatility USA ETF takes a more holistic approach to portfolio construction. It basically strives to construct the least volatile portfolio possible under a set of constraints. To do this, it considers both individual stock volatility as well as the correlations across stocks. So, a stock with high stand-alone volatility might make the cut if it has low correlations with other stocks in the portfolio. Now, this leads to a better diversified portfolio that should mitigate exposure to sources of risk that past volatility alone may not capture. This strategy also limits its sector tilts to within 5 percentage points of the market, which helps it avoid some of the large sector bets that the Invesco fund makes. This holistic approach should make the iShares fund a better core holding than the Invesco fund over the long term.   

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