Did Low-Volatility Funds Live Up to Their Names Last Week?

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Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar.com. Coronavirus fears have injected much uncertainty into the market. As such, investors may be looking for ways to de-risk their portfolios. Should low-volatility funds be something to consider? Joining me today to discuss is Alex Bryan. Alex is Morningstar's director of passive strategies in North America and editor of ETFInvestor. Alex, thank you so much for joining us today.

Alex Bryan: Thank you for having me.

Dziubinski: Now, let's step back a little bit and first talk about what are low-volatility funds, and what are the different strategies that these funds use?

Bryan: Low-volatility funds are effectively strategies that try to provide investors a smoother ride than the overall market, which should translate into lower downside risk. The trade-off here is that you give up some of the market's upside, but over the long term they should provide a more attractive risk/reward trade-off than the overall broad market. And there's a couple of ways that these strategies are implemented, but that's the basic idea.

Dziubinski: Let's talk a little bit about the different strategies. Tell us a little bit about the first one and maybe a couple of ideas you like there.

Bryan: The simplest approach is to basically target stocks that have exhibited low volatility in the recent past, based on the assumption that stocks with low past volatility will likely continue to exhibit low risk going forward. So if you think about this, this tends to tilt toward stocks like utilities, consumer defensive names, in some cases, healthcare names. These types of stocks tend to be a little bit less cyclical than most. So, in times when the economy is not doing so well, they tend to have better earnings than the more cyclical stocks.

So, a fund in this group that I like is Invesco S&P 500 Low Volatility ETF. The ticker is SPLV. This fund effectively winds up the stocks in the S&P 500 based on their volatility over the past year and targets the least volatile 100. Now, one of the issues with this strategy is you do tend to get some very large sector concentrations from time to time. So, this fund right now has a lot of exposure to utilities and to REITS. There's going to be times when that works out. There's going to be times when that may not pay off. So, it's important to keep that in mind, but overall, it's done a really good job of cutting downside risk.

Dziubinski: And then there's another cadre, another group of low-vol funds. Tell us a little bit about how they work and maybe a fund you like there.

Bryan: The other approach is to take a more holistic approach to portfolio construction where you're not just looking at past stock volatility but also at how stocks interact with each other in a portfolio. So, for example, if a stock, like a gold miner has really low correlation with other stocks, it may actually make the cut for a low-volatility portfolio, even though on its own, it may have high volatility.

So, a fund that I like here is the iShares Edge MSCI USA Minimum Volatility ETF. The ticker is USMV. This fund basically uses an optimizer to try to construct the least volatile portfolio possible under a set of constraints to improve diversification. This includes limiting sector tilts relative to the market. So what you end up with is a really well diversified portfolio that mitigates exposure to the sources of risk that you may not anticipate, but it also still favors those types of defensive names that you get with that Invesco fund that uses a more simplistic approach. But I do like this type of a strategy as a way of really building a strong core portfolio.

Dziubinski: So, the million-dollar question is: How did these low-vol funds do last week when the S&P was down double digits?

Bryan: Last week was a bad week for the market. I mean, the S&P 500 lost more than 11%. And these two funds last week did about as poorly as the market did. And that I think brings up an important point. While these strategies have done a good job of cutting downside risk, if you look at the returns over any rolling one-year period that you want to look at, they're not always going to be down less than the market on days when the market is down.

So, if you have a really short-term horizon, if you're really worried about what's going to happen to the market this week or next week, the better solution may be just to own more cash or more bonds and less in the stock market because it's really hard to say whether these are going to do better or worse than the market over a very short window like that. But if you have a longer investment horizon, like, let's say, a year, three years, five years, I think it's a really good bet that in months when the market is down, these strategies should hold up a little bit better.

Dziubinski: So are there any types of investors in particular who might be more or less interested in pursuing these funds a little bit or learning more about them?

Bryan: I think these are really appealing strategies for risk-averse investors who still want exposure to the stock market. These funds are still going to participate in the market's upside. And over the long term, that's been a good place to be, but they help mitigate some of the volatility that you might otherwise get with a stock portfolio. Now, these are still stock funds. They're still 100% invested in the stock market, so these should not be seen as bond replacements. They're still going to be risky. They're still stock funds, but I think if you are more risk- averse, these are very appealing types of strategies to look at.

As I mentioned, I think the iShares funds, which uses this more holistic approach to portfolio construction, might be a better core holding for a risk-averse investor, and the Invesco fund, which uses this more pure approach of just targeting stocks with low volatility, that might be a better satellite holding for someone who just wants to tilt their portfolio a little bit toward defensive stocks. Because, while it is more style-peered than the iShares fund, it does have those sector risks that come into play. So if you're going to own that fund, it's better to keep that a small portion of your overall portfolio.

Dziubinski: Alex, I want to thank you again for your time today. Great information.

Bryan: Thank you for having me.

Dziubinski: I'm Susan Dziubinski from Morningstar.com. Thank you for tuning in.

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