Is there a need for low-volatility ETFs?

You may not need these premium-priced ETFs because volatility can be reduced in other ways.

Larry MacDonald 0

(Photo: Martin Barraud/Getty)

Low-volatility exchange-traded funds (ETFs) are one of the more successful products to be launched by the ETF industry recently. Tracking low-beta stocks, they fluctuate less than the market, making these ETFs 20% to 30% less variable than benchmark indexes. The most popular is the PowerShares S&P 500 Low Volatility ETF, which charges an annual fee of 0.25%. By comparison, the iShares S&P 500 Index ETF, which tracks the more volatile broad market, charges 0.09%.

But volatility in investment returns can be smoothed in other ways. Dividend ETFs, for example, are also low volatility and can be used instead. Additionally, studies show that low-beta strategies are equivalent to increasing the relative weight of utility, consumer-staple and regulated industries—so one could design a portfolio with a similar weighting pattern. And apprehensive investors can work on their investing psychology to become, like seasoned investors, less bothered by the market’s ups and downs.

But perhaps the most tried and tested way of dealing with market volatility is through the use of basic portfolio-management rules. Long before low-volatility ETFs made their debut, investors desiring less volatility would simply decrease their allocation to stocks and increase their allocation to fixed-income securities, such as bonds. In other words, their target for asset allocation was more conservative.

They could further control volatility by rebalancing. If the stock market went on a bull run and pushed the relative importance of their stock position higher, they would rebalance back to the target by selling off some stocks and buying bonds (or by feeding new infusions of money into bonds).

These portfolio-management practices can be tweaked in various ways to smooth out portfolio returns to the desired comfort level. For example, ultraconservative investors can slash their stock position to 30% of their portfolio and rebalance whenever it rises to 35%.

Some observers seem to think the old rules of portfolio management no longer apply when bond prices have been bid up so high, and now appear poised to fall and inflict capital losses on bondholders. This shouldn’t be a problem if bonds are held to maturity (as is common practice).

It might be more of a problem for bond ETFs due to the lack of a maturity date on ETFs. In this case, one solution may be to switch to individual bonds, GICs or high-interest savings accounts.

But these savings vehicles pay minimal interest, so some investors may be tempted to go into low-volatility ETFs instead. Proponents say they can keep volatility down and still generate high returns because of dividend income and the capital gains earned on stocks.

However, low-volatility ETFs will not likely be of much comfort if the next crash leads to substantial market losses. Low-volatility ETFs themselves could be down 20% or more. That is still a gut-wrenching plunge for most, leading nervous investors to cut and run at the worst time.

To stay on an even keel during the tumultuous times, risk-adverse investors need a significant weighting in cash and conservative fixed-income securities. Interest rates may be at rock bottom, but if a portion of your income position is scheduled to mature and roll over into new maturities every year (ladder formation), interest rates earned can rise along with market rates whenever they go up. Keep in mind that some savings vehicles, such as high-interest savings accounts, will automatically track market rates higher.

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