What You Need to Know About Low-Volatility Funds (Part 2)

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 five-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 difference 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 outflows that these funds 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 outside the next time you’re tempted to tinker with your portfolio.

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