- Minimum volatility ETFs (commonly referred to as "min vol" ETFs) attempt to reduce exposure to stock market volatility.
- These funds track indexes that aim to provide lower-risk alternatives relative to more risky investments.
- Min vol ETFs do not ensure against losses.
A year ago, in August 2019, primary risks investors were coping with included global trade wars and, to a lesser extent, a yield curve inversion—which some investors perceive as being a harbinger for an impending recession.
Fast forward to today, and those risks seem trivial. COVID-19 sent the unemployment rate skyrocketing well into double digits, consumer confidence has plummeted to a 6-year low, and the upcoming US presidential election has investors' plates full of uncertainty.
Yet historic monetary support, fiscal stimulus, and persistently strong earnings from a significant percentage of public companies backstopped the market, sending US stocks to new all-time highs.
With that said, you should know that there are strategies that may help mitigate the level of portfolio volatility if volatility does strike. Beyond mitigating risk through appropriate diversification, if you wish to retain long-term exposure to equities and would like to reduce shorter-term volatility, one investment solution worth considering is a minimum volatility ETF.
Diversification is a tried-and-true portfolio management technique. While neither diversification (within an asset class, such as stocks) nor asset allocation (diversification across asset classes, such as stocks, bonds, and other investments) ensures a profit or guarantees against a loss, both can be effective ways to manage long-term fluctuations in the market. If you are diversified, you might simply prefer to wait out market volatility.
Some active investors may want to consider more tactical approaches. During periods of expected heightened market volatility, you may be thinking about reducing your exposure to riskier positions. If volatility is subsequently expected to be lower, you can get back into positions you would invest in under normal market conditions that also align with your risk and return objectives. It can go without saying that this requires a commitment of time and a level of skill that most individual investors may not have.
One strategy that investors might consider to reduce exposure to volatility is an exchange-traded fund (ETF) known as minimum volatility, or min vol. You might also see these types of investments referred to as low volatility ETFs.
A min vol ETF (as well as other min vol investment vehicles) attempts to reduce exposure to volatility by tracking indexes that aim to provide lower-risk alternatives to other riskier investments. For example, a min vol ETF might exhibit less risk during market turbulence compared with a broadly diversified index such as the S&P 500.
There are other investment vehicles that attempt to mitigate exposure to volatility, including minimum volatility mutual funds and low volatility managed accounts. Many min vol investments are heterogeneous (i.e., they have different exposures and upside/downside profiles). Min vol strategies come in a variety of forms, including single asset class, multi-asset class, long-only, long/short, risk parity, and downside managed.
A min vol ETF does not eliminate risk exposure to volatility. Low volatility funds may underperform non min vol funds with similar asset class exposures when the broad market is doing well, and they can experience declines during sharp corrections. However, the expectation for a min vol ETF investor is that any potential losses during a market decline might be smaller relative to other investments that may have more exposure to volatility. As a result, a less risky portfolio could recover more quickly than the broad market after a downturn when stocks recover.
Some characteristics that an investor might use to evaluate a min vol ETF include risk and return measures like R-squared, beta, standard deviation, upside/downside capture ratio, and historical performance. You can find these on Fidelity.com when you select a particular ETF.
Additionally, min vol ETFs can be used to lower overall portfolio risk. For instance, if your portfolio consists largely of cyclical stocks, a min vol ETF might diversify away some risk exposure in the event that the market becomes volatile. If you want to reduce your exposure to volatility if, for example, you think there may be an increase in short-term volatility, and you like the benefits of ETFs, a min vol ETF could be right for you.
It should be noted that the nature of how low vol funds are constructed can mean investors who rely too heavily on them could end up with portfolios that are concentrated in large-cap defensive stocks and light on small-cap growth stocks.
Minimum volatility ETFs
Assuming you like to make tactical adjustments to your investments (and you are comfortable with the long term risk/return characteristics of your asset mix), min vol investment choices may help you execute your strategy if you are concerned about a short-term market decline. If you want to explore min vol ETFs, here are the 5 largest by net assets:
- iShares Edge MSCI Min Vol USA ETF (USMV)
- JPMorgan Ultra Short Income ETF (JPST)
- iShares Edge MSCI Min Vol EAFE ETF (EFAV)
- Invesco S&P 500® Low Volatility ETF (SPLV)
- iShares Edge MSCI Min Vol Global ETF (ACWV)
Other volatility strategies
There are several other ways that investors may be able to weather an increase in volatility. Bonds, for example, tend to be less volatile than stocks. When the stock market is expected to be more volatile, tactical investors may want to consider increasing their bond allocation. It is worth noting that the bond market is not immune to volatility.
High-yielding stocks are another opportunity that investors can explore. The income component of high-yielding stocks tends to make these investments less volatile than more cyclical stocks, which have lower or no dividend yield. Of course, the 2008 financial crisis highlights that even this strategy may not be immune to severe market stress.
You could also consider industry/sector specific mutual funds that have historically exhibited lower volatility, relative to the broad market, as well as managed account solutions—particularly those with a defensive strategy.
Additionally, there are several options strategies, including straddles, strangles, and other spreads, which can be used to take advantage of expected market volatility.