Even though US stocks remain within striking distance of all-time highs set earlier this summer, it may feel like recession fears have ratcheted up over the past several weeks. The yield curve inversion, global trade wars, new moves by the US central bank, and other developments have led some investors to question whether the 10-year bull market may be slowing.
If volatility strikes, you should know that there are volatility strategies that may help protect your portfolio. In addition to diversification, one investment choice that you might consider is a minimum volatility ETF.
Diversification is a tried-and-true portfolio management technique. While neither diversification nor asset allocation ensures a profit or guarantees against a loss, both can be effective ways to manage long-term fluctuations in the market. Other investors may simply prefer to wait out market volatility—a buy-and-hold approach.
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.
One strategy that active 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 attempts to reduce exposure to volatility by tracking indexes that aim to provide lower-risk alternatives. 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. Some min vol ETFs accomplish this objective by purchasing securities that exhibit relatively low volatility and concentration risk (i.e., heightened exposure to a particular asset class, investment characteristic, or other risk factor that results from a heavily weighted allocation). It is worth noting that some min vol ETFs may not have lower concentration risk than broadly diversified market indexes.
Of course, a min vol ETF does not eliminate risk exposure to volatility, and may not prevent a loss in the event of a downturn. Low volatility funds may underperform 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. Many min vol investments are heterogeneous (i.e., they have different exposures and upside/downside profiles).
Moreover, these types of funds might not only be considered in advance of a potential weak market. Many min vol ETFs tend to be skewed toward more defensive sectors, such as consumer staples and health care, and so they might perform well when those segments of the market are expected to do well—within the framework of the business cycle. Of course, 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
If you are concerned about a US stock market decline, you may want to consider researching min vol ETFs, the largest of which by net assets are:
- iShares Edge MSCI Min Vol USA ETF (USMV)—Available for purchase commission-free on Fidelity.com
- Invesco S&P 500® Low Volatility ETF (SPLV)
- iShares Edge MSCI Min Vol EAFE ETF (EFAV)—Available for purchase commission-free on Fidelity.com
If you have global investments and are concerned about some of the volatility risks that have emerged out of China, Europe, and other parts of the world, there are also non-US min vol ETFs. The largest non-US min vol ETFs by net assets are:
- iShares Edge MSCI Min Vol EAFE (EFAV)—Available for purchase commission-free on Fidelity.com
- iShares Edge MSCI Min Vol Emerging Markets ETF (EEMV)—Available for purchase commission-free on Fidelity.com
- iShares Edge MSCI Min Vol Global ETF (ACWV)—Available for purchase commission-free on Fidelity.com
Other volatility management possibilities
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, 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 select 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.
Whether you take a more passive approach to managing your investments, or want to actively implement strategies that seek to reduce your exposure to market volatility, there are a number of ways to position your portfolio. Recent market events suggest now may be a good time to evaluate your investments to determine if you are positioned how you'd like to be.
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