A couple of years ago a new kind of fund, the low volatility ETF, was first offered by fund companies. It fits in a new fund category known as smart beta, which offers a different way to weight index funds outside of the typical market cap weighting used by most indexes.
It didn’t take long for these new funds to become popular. Much of that popularity is due to its initial performance. The funds did more than advertised and investors started chasing returns. But are low volatility ETFs actually worth it? Or is there a better option?
Fund Companies Saw An Opportunity
To explain this we need to go back to 2009 and 2010. The stock market was the last place many investors wanted to be. It was choppy, very volatile. There were strings of days were the S&P 500 would rise and fall 5% or more. It was a rollercoaster ride. People were ditching stock funds in droves for “safer” bond funds (which we later found out weren’t nearly as safe as we thought).
The idea was to offer an ETF that smoothed out those peaks and valleys in the short-term. The fund, by its very nature, should offer more protection when the market is going down than you would get from a comparable market cap weighted fund.
To do that, they had to put together a portfolio of low volatility or low beta stocks. In 2011, several of these low volatility funds were introduced, then marketed as a “rest easier at night” fund product. The two more popular were the: S&P 500 Low Volatility ETF (SPLV) and MSCI USA Minimum Volatility ETF (USMV).
Low Volatility and Beta
Low volatility investing is nothing new. Beta has been used to measure stock and fund volatility for decades. It’s not that difficult to find low volatility funds. A simple fund screen will do it. You just need to understand how beta works.
Beta measures the historic volatility of a stock or fund as it relates to the overall market. In other words, it measures how often and by how much a stock price bounces up and down compared to the S&P 500.
- Beta of 0 to 1 – less volatile than the market.
- Beta of 1 – as volatile as the market.
- Beta higher than 1 – more volatile as the market.
Low beta funds typically do better than the overall market when the market is going down, but underperform the market when it’s going up. Alternatively, high beta funds typically do better than the market when the market is going up and worse when the market is going down.
Low Cost Alternatives
Several types of stocks are viewed as low beta, low volatility: utilities, telecoms, blue chips, and other large cap stocks that pay a higher dividend. A low volatility ETF is just a combination of these wrapped in a fancy name with a higher price tag slapped on the side.
I’m willing to bet you’re invested in low volatility stocks through the funds you currently own. And you’re doing it without paying the higher costs. In case you’re not, finding a low-cost, low beta alternative is easy.
The most popular low volatility ETF, the SPLV, has an expense ratio of 0.25%. To do this right, we need a diversified, low cost fund with a beta less than 1. A simple ETF screen for equity funds, expense ratio under 0.25%, and beta less than 1 gives 36 results. Out of those, these funds met the screen criteria best:
- Vanguard Dividend Appreciation Index ETF (VIG) – 0.10%
- Vanguard High Dividend Yield Index ETF (VYM) – 0.10%
- Vanguard Consumer Staples ETF (VDC) – 0.14%
- iShares Russell Top 200 ETF (IWL) – 0.15%
- Consumer Staples Select Sector SPDR (XLP) – 0.17%
You can do similar screens to find low beta alternatives for low volatility international and emerging markets funds.
The most generic asset allocation strategies include large cap and higher dividend stock funds. The point is to protect your money when the market is going down. Protecting against short-term volatility is already built into a basic asset allocation strategy.
So far, the jury is still out on whether smart beta is actually better. For now, low volatility ETFs are a way for fund companies to charge higher fees for something you can do yourself. Long term investors are likely better off sticking with a regular mix of low-cost funds that fit their goals and asset allocation.